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BS2003-01b
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Accounting fraud
Part II: The results
Creative accounting is not a new technique, but it can certainly be a costly one. Businesses feel the pressure to appear profitable in order to attract investors and resources, but deceptive or fraudulent accounting practices often lead to drastic consequences. Are these so-called creative practices always illegal or can they ever be justified? This case study will present examples of companies who have used inappropriate accounting practices, the results of their deceptions and the government's plan to avoid future incidents.
52%
45%
Agree
Disagree
Source: Edelman Public Relations Worldwide/ StrategyOne Research survey of 400 respondents.
1 College educated 35- to 64-year-olds with household incomes of more than $100,000 2 Does not add up to 100% due to rounding
By Darryl Haralson Marcy E. E. Mullins, USA TODAY By Darryl Haralson andand Marcy Mullins, USA TODAY
And a sale may devastate Coudersport, Pa., where Adelphia is headquartered. It's by far the largest employer in the rural, mountain town of 3,000. Meanwhile, Adelphia will tr y to reassure its subscribers. "Adelphia is committed to reversing its admittedly difficult present financial situation," it wrote last week to 3,500 franchise officials. "Most importantly, there should be no change in service to Adelphia customers as a result of these developments." Adelphia's downfall began on March 27, when it disclosed that a Rigas family partnership had borrowed $2.3
billion using company assets as collateral. The amount has since been raised to $3.1 billion. That stunned analysts, who believed that the operator was already too deeply in debt. Barraged with questions, Adelphia put off release of its 2001 annual report. More questions were raised when it was confirmed that the SEC was investigating. As the stock plummeted, Nasdaq weighed delisting Adelphia shares. That took effect on June 3. After acknowledging that it would have to restate its earnings, Adelphia
put several cable systems on the block. The company defaulted on bank loans and failed to make interest payments on bonds. And Rigas and sons Timothy, Michael and James were forced to relinquish their jobs and board seats. Then new interim CEO Erland Kailbourne stunned company watchers by disclosing a series of cases where the Rigas family allegedly used Adelphia for private gain. Among other things, the company paid for their apartments in New York, built a golf course on Rigas-owned land, helped the purchase of the Buffalo Sabres hockey team, created a Rigas-run investment firm and subsidized a documentary film.
Cover story
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Bankruptcy Court in New York. The Rigases could be forced to pay three times any damages the court finds. The lawsuit alleges about $1 billion in damages. Behind their "small-town facade," the Adelphia lawsuit says, the Rigases "used their domination and control of Adelphia, and their isolation from the scrutiny of the outside world, to engage in one of the largest schemes of selfdealing and financial wrongdoing in American corporate history." The Justice Department and the U.S. Postal Inspection Service charged the five executives with securities, wire and bank fraud, saying they "looted Adelphia on a massive scale" and used it as a "personal piggy bank." Rigas private funds sloshed with Adelphia's in the same cashmanagement system. A U.S. judge set bail for the Rigases at $10 million apiece, secured by cash and property. Allegations against the Rigases range from big schemes to hide financial problems at the cable company to relatively small-scale thievery. For example, Timothy was accused of using a company jet for an African safari vacation in 2000. Adelphia's lawsuit adds that John's daughter, Ellen, used company planes to bring guests to her wedding to Peter Venetis, who became an Adelphia board member. The couple's cozy position enabled them to save $150,000 since 1998: They lived rent-free in two Adelphia-owned apartments on Manhattan's swank Upper East Side, the lawsuit says. In less than four years, the Rigases "stole hundreds of millions of dollars, and through their fraud (and) caused losses to investors of more than $60 billion," Deputy Attorney General Larry Thompson says. The defendants could face jail time in the criminal case. By filing a complaint instead of a full-fledged indictment, the grand juries weighing evidence in the case can remain empaneled to approve charges against others. They have 10 days to indict those arrested, and 20 days to charge others. Also Wednesday, the Securities and Exchange Commission filed a civil lawsuit in U.S. District Court that's similar to the criminal complaint, and includes a third Rigas son, James. The SEC would bar the defendants from serving any publicly owned company. It also wants them and Adelphia to pay restitution and fines. Adelphia said in a statement that the claim against it
would "only have the effect of further penalizing the company's stakeholders who were the victims of the Rigas' improper conduct." The Adelphia cases are low-hanging fruit for prosecutors eager to show that they're getting tough on white-collar criminals. "This is an old fashioned hand-in-the-till case that's easier to prosecute than an esoteric fraud like Enron," says Jack Coffee, who teaches securities law at Columbia University. "To prosecute Enron, you're going to have to teach the jury an intermediate college course in accounting." Jacob Frenkel of Smith Gambrell and Russell agrees. "This could be sexiest of all the cases," he says. "Here, you're talking about corporate looting. Every guilty disposition arising out of this indictment should become a show-andtell in all business schools as the antithesis of public company management and stewardship." Talking tough, getting tough The arrests came as House and Senate negotiators agreed on tough measures, including jail time, for executives convicted of fraud. And Wall Street was impressed after weeks of growing fearfulness about a possible tsunami of corporate scandals. The Dow Jones industrial average soared 489 points Wednesday. That's the second biggest one-day point gain ever. That contrasts with the 179-point drop on July 9, when President Bush called for a new era of corporate responsibility. The arrests aren't "about Democrats and Republicans," says Lynn Turner, former chief accountant of the SEC under President Clinton. "This is about investors, and they like what they're seeing now." Even people who aren't obsessed with stocks seem to like the idea of big shots getting a comeuppance. "We are angry, and we have every right to be angry," says futurist and consumer expert Marian Salzman of Euro RSCG Worldwide. "There's a feeling that we need to kick out the evil-doers in the industry." But some might recoil at the image of a dignified old man being led before the cameras in handcuffs. "They're actually going to look sympathetic," says Robin Cohn, author of The PR Crisis Bible. "Why would you
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handcuff an old man? He's not a murderer and a rapist. That's not to say they aren't crooks.But I think the public would rather see somebody they know in handcuffs like (former Enron CEO) Ken Lay." And the incident could make the government look somewhat silly, she says. "I can't imagine Saturday Night Live not doing anything with this." Corporate crime is in the spotlight these days. Last month, federal prosecutors arrested former ImClone CEO Sam Waksal on charges of illegal trading on inside information and obstruction of justice. Their investigation has expanded to include friends and family of Waksal, who also might have illegally traded on inside information about ImClone last December. Investigators are trying to determine whether any inside information was passed to Waksal's friend Martha Stewart, who sold her ImClone stock just before a Food and Drug Administration announcement, denying an application to market a cancer-fighting drug, drove the stock price down. In coming months, the Justice Department is expected to charge top executives of Enron and WorldCom with fraud. The department's Enron Task Force won one court battle last month when a Houston jury found auditor Arthur Andersen criminally guilty of obstruction of justice. It appears, though, that officials wanted to start off with a bang as they arrested the Rigases. "What's unusual here is the level of detail included in the criminal complaint, and the number of defendants arrested simultaneously," says former prosecutor Robert Mintz, now at McCarter & English. "Usually, the government builds a case slowly, with eventual defections among defendants. Here, it has leveled a wide range of allegations against upper management. That suggests that the government believes it has strong case and that they expect a rush to the prosecutor's door by defendants who will vie to strike deals." The cases build on information that began to come out in late March. Adelphia disclosed then that the Rigases had used assets of the already debt-heavy company to secure loans to private, family-run partnerships. That borrowing is now put at $3.1 billion. Independent directors forced the Rigases out of their executive positions and board seats, installing former
banker Erland Kailbourne as interim CEO. When they investigated the company's condition, they found and disclosed case after case in which the Rigases made no distinction between their personal funds and businesses and Adelphia's. Bad news gets worse But Adelphia was already in a tailspin. Investors lost confidence. Auditors refused to certify the company's financial reports. And lenders cut it off, leading the company to miss interest and dividend payments. Among the charges leading to the Rigases' arrest: u That the family began using Adelphia as collateral for private loans in 1996, even though the company "was one of the largest junk bond issuers in the United States." Investors weren't told. u That the Rigases secretly inflated Adelphia's cable TV subscription numbers to make investors think it was still growing at a healthy pace. In 2000 they began to count subscribers from systems in Brazil and Venezuela, where Adelphia owns a minority stake. In 2001, Adelphia began adding customers who just ordered high-speed Internet services from the Rigases' non-Adelphia systems. And earlier this year, they folded in people who ordered home security services from Adelphia. u That they used accounting legerdemain to disguise Adelphia's actual expenses for digital decoder boxes. In 2001 the company claimed that it sold 525,000 boxes for $101 million to an unaudited Rigas-owned company that has no cable systems. u That, starting in 2000, Adelphia spent $13 million to build a golf club on land mostly owned by John Rigas. u That in 1999, they told analysts that Adelphia could provide two-way communications to 50% of its customers. The real number was 35%. u And that the Rigases took more than $252 million from Adelphia to pay for margin calls on their purchases as the company's stock price fell. Contributing: Michael McCarthy
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celebration on the Mall in Washington was supposed to be paid for by WorldCom, which has sponsored part of the festivities for five years. But the company pulled out. The National Parks Foundation scrambled to find new funding from AT&T. Also in Washington, the MCI Center arena might soon be looking for a new sponsor and name. The WorldCom Classic, an annual PGA Tour stop in Hilton Head, S.C., is in the same situation. u Charities. Each month, about 10,000 teachers receive free training in math, science and the arts from the MarcoPolo project, which is sponsored by WorldCom's charity arm. Now, program administrators and partners including the National Geographic Society, American Association for the Advancement of Science and The Kennedy Center are tr ying to make the proj ect independent of the struggling company. Last week, they pulled WorldCom's logos from the MarcoPolo Web site. They're applying to make it a "public charity," says Caleb
Schutz, president of WorldCom Foundation. "There's a lot to lose if the company . . . pulled the plug." For now, WorldCom still funds MarcoPolo. u Customers. The Texas Parks and Wildlife department spent last week printing temporary fishing and hunting licenses as a quick contingency plan. The department relies on a WorldCom computer network to transmit license information to 2,500 vendors. "We certainly have to consider what might happen to our contract," says Suzy Whittenton, a wildlife director. Webhelp, which outsources customer service for companies such as Microsoft, uses WorldCom to connect its overseas technology specialists with help-seekers in the USA. Because of a contract, Webhelp can't switch providers but was forced to get a backup provider in case WorldCom fails. That means twice the bills. "It's expensive, and at the end of the day, our clients pay for that," says CEO Adler.
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As the Enron and WorldCom examples demonstrate, theres no room in a public marketplace for creative accounting. Once a few cheaters are revealed, the integrity of the entire marketplace is open to question. Greg Farrell is a reporter in USA TODAYs Money section. He writes about fraud and white collar crime. In the past year, he has been reporting on Enron, Arthur Andersen, Martha Stewart and the Securities and Exchange Commission.
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For discussion
ADELPHIA PLANS TO FILE CHAPTER 11; ADELPHIA FOUNDER, 2 SONS, 2 OTHERS ARRESTED IN FRAUD (LIEBERMAN AND FARRELL) 1. Adelphia Corporation was the sixth largest cable company at the time of its collapse. The company was accused of a number of fraudulent activities including the manipulation of its financial reports. Specifically, the firm was accused of misreporting its cable subscription numbers in order to give the impression that the firm was growing faster than it was. For example, they counted subscribers from systems in Brazil and Venezuela where the company owns a minority stake in the companys total subscribers. They also counted customers who ordered high-speed Internet services from companies owned by the Rigas family and clients that ordered home security services from Adelphia. Why would Adelphias management engage in what appears to be blatant misrepresentation of their number of subscribers? 2. When CEO John Regas of Adelphia was led away in handcuffs on racketeering charges, some complained that the justice department was making too public a display of its tough stance on white-collar crime. This type of treatment is normally associated with murderers and rapists. How do you feel about the importance of making a public spectacle of white-collar criminals? 3. The Adelphia lawsuit stated that the Rigases "used their domination and control of Adelphia, and their isolation from the scrutiny of the outside world, to engage in one of the largest schemes of self-dealing and financial wrong doing in American corporate history." Financial economists refer to this type of behavior as an agency cost since corporate executives are the agents of the firms owners or principals. How can stockholders protect themselves from the potential for self-dealing by corporate executives? ANDERSENS PARTNERS CHART FIRMS FUTURE TODAY (FARRELL) 1. Arthur Andersen was once the premier public accounting firm but a string of high profile financial reporting disasters that culminated with the failure of Enron caused the demise of the once proud firm. Andersens failure highlights the fact that the principal asset of a public accounting firm is the firms reputation. Once the firms "credibility" is challenged its clients are no longer willing to pay for its auditing services. What is it that a public accounting firm does that requires it to have a sterling reputation for honesty? 2. Andersons initial lay off was 7,000 of its 26,000 employees before the firm completely collapsed and all employees lost their jobs. However, all of Andersens clients still needed auditing services so in many instances the employees continued to audit the same firms they had audited for Andersen, just for another auditing firm. If the employees just moved from one firm to another, was there really a layoff? Did Andersen employees really suffer from the demise of Arthur Andersen? Isnt this also true of the Adelphia, Enron, and WorldCom employees?
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Future implications
WORLDCOM SCANDAL BRINGS SUBPOENAS, CONDEMNATION (BACKOVER AND VALDMANIS); DOMINOS HIT WORLDCOM PARTNERS, CLIENTS (KESSLER) The financial press coverage of the failures of Adelphia, Enron, and WorldCom have focused principally on stockholders who have lost everything they invested and creditors who stand to lose a portion of what they have loaned the company. However, other important consequences of these high profile failures are often overlooked including: (1) the financial and emotional losses suffered by employees who lose their jobs and face the prospect of a lengthy period of unemployment and possibly the dislocation costs of moving to another community to find work, (2) the local community public services and school systems who lose valuable tax revenues, and (3) the budget crises created for local charities and the arts that depend on corporate contributions for their continued survival. Bankruptcy courts focus on the contractual obligations of the firm to creditors and suppliers. It has been argued that the corporation is a "guest" of the society and as such has obligations to the entire web of stakeholders that have a financial stake in the firms survival. Should the claims of these "silent stakeholders" also be considered when a firm fails?
Additional resources
Working Paper Series Financial Engineering, Corporate Governance, and the Collapse of Enron http://www.be.udel.edu/ccg/research_files/CCGWP2002-1.pdf
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