Infectious Greed (34 page)

Instead, at this point, the major changes in financial markets took a new turn. The financial virus spreading through the markets, which previously had involved primarily new
risks,
broke through a significant barrier and began to involve new methods of
deceit
. This was the beginning of the time Alan Greenspan was referring to when he told the Senate Banking Committee in 2002, “An infectious greed seemed to grip much of our business community.”

In a few years, new financial instruments would return to U.S. corporations—often in transmuted form—and the mix of risk and deceit would prove even deadlier. Until then, simple deceit alone would do plenty of damage.

 

 

D
uring the previous two decades, Walter Forbes had built the world's largest consumer-services company, CUC International, with 68 million members of various auto, dining, shopping, and travel clubs. CUC was the “middleman” between consumers and manufacturers—like a gigantic corporate Avon Lady—and it made money primarily by selling club memberships, which—like Avon, or even Costco or the Book-of-the-Month Club—entitled the holder to new products and discount prices. Its biggest club was called Comp-U-Card (hence the name “CUC”), but Forbes also had partnerships with major catalog retailers, including Sears. Probably half of the readers of this book have been members of some CUC-related club.

From the beginning, Comp-U-Card executives faced a difficult problem: how should they record revenues and expenses associated with membership sales? Suppose CUC sells a 3-year membership that costs $60 per year, payable quarterly. How much revenue should CUC recognize in its next quarterly financial report? The entire $180 it expected to receive during the three years of membership? Or just the $15 it expected to receive in the first quarter? Or some intermediate amount, perhaps adjusted for expected cancellations, interest rates, or inflation? Expenses weren't any easier. How much of CUC's salaries, overhead costs, and other solicitation expenses should it allocate to a membership it sold? And when?

CUC managers developed a grid to project how much revenue and
expenses to reflect over time, based on the company's experiences with cancellations and costs. The goal was to match membership-sales revenues with corresponding expenses. Such a grid was precisely what investors and analysts would expect from a company facing thorny questions about revenues and expenses. So long as CUC used the grid consistently, it would be possible to track the company's business accurately over time.

However, Walter Forbes and CUC's executives wouldn't necessarily benefit from disclosing accurate earnings. By 1994, CUC's membership growth was slowing, and earnings were volatile. If CUC could “manage” its earnings to meet the expectations of analysts and investors, its stock would be more valuable. Here is why.

Major investment banks had securities analysts who rated stocks, typically in one of three categories: buy, hold, or sell. Investors followed these ratings, and higher-rated stocks were more valuable. Analysts (and investors) wanted to see earnings that increased, year to year, and they didn't like surprises. The more predictable corporate earnings were, the more investors would trust the analysts, the more money the analysts would make, the more “buy” ratings they would issue, and the higher stock prices would be. In 1994, companies ranging from AT&T to Enron to General Electric were managing their earnings, and there were a lot of happy analysts; only about one percent of ratings were “sells.” There were a lot of happy investors, too.

To please the analysts, CUC began manipulating its grids, adding “allocation” columns, so that executives could manually shift revenues from one period to another.
³
But CUC executives took earnings management a step farther, sometimes ignoring the grids entirely and, instead, simply typing into the computer spreadsheet new numbers that tracked CUC's earnings to better match the expectations of analysts. Those numbers magically became the firm's revenues and expenses for a given period. Over time, CUC's accounting system began to resemble the one Joseph Jett used at Kidder Peabody, recognizing false profits today and pushing losses off until tomorrow, disguising the reality that CUC was losing money.

CUC's executives refined their earnings-management scheme during the mid-1990s, until they were recognizing tens of millions of dollars in additional revenues prematurely and pushing similar amounts of expenses into the future. For example, when Comp-U-Card members cancelled memberships during the fourth quarter of a year, CUC would
hold that cancellation off the books until the following year. Executives also began stretching expenses associated with memberships across three years, instead of recognizing them within the year they were sold.
⁴
If the expenses associated with a membership were $30, CUC would switch from recording an expense of $30 in the first year to recording $10 per year for three years, thereby pushing two-thirds of its expenses into the next two years.

These tricks worked very nicely in the short run. However, investors and analysts expected CUC's earnings to continue to grow, and after a few years CUC executives had milked its membership sales for as much as they could. The accounting firm of Ernst & Young—the successor to Arthur Young, the firm that was implicated in the cover-up of Andy Krieger's $80 million of missing profits at Bankers Trust—had approved of CUC's prior financial statements, but the accounting firm was only willing to go so far. By 1996, the deferred expenses were coming due, and there were no real profits to offset them. CUC would either have to declare a loss or find another source of additional false profits.

Walter Forbes considered his options—both literally and figuratively. CUC had granted Forbes millions of stock options, and if CUC declared a loss, he would lose tens of millions of dollars. However, if he could find a merger partner, he might be able to buy more time by hiding the losses elsewhere, and perhaps even pick up more stock options from the merger.

Forbes met with Henry R. Silverman, founder and CEO of HFS International, a company that owned hotels (Days Inn and Ramada), real estate (Century 21 and Coldwell Banker), and other franchises (HFS stood for Hospitality Franchise Systems). Wall Street loved Henry Silverman. He had banking experience at the prestigious Blackstone Group, and analysts loved the predictable earnings of his brand-name franchises (never mind that many of them were near bankruptcy). HFS was one of the best-performing stocks in the rapidly rising market of the mid-1990s.

Forbes and CUC presented an intriguing opportunity for Silverman. Forbes's club members were potential customers of Silverman's franchises, and vice versa. CUC members could buy homes through Century 21; guests at Ramada hotels could sign up with Comp-U-Card. In addition, HFS could partner with CUC's Internet website, called
Netmarket.com
, which Forbes claimed “will sell 90% of what you'd want in your home.”
⁵

CUC's new “online mall” was attractive to HFS for two reasons. First,
Netmarket.com
already had 700,000 members who had bought
$1.2 billion of consumer products.
⁶
Those were people who might use HFS franchises. Second, Internet retailing seemed to be a brilliant new business model, and Forbes and Netmarket were among the very few firms in this new “space.”
Amazon.com
—which in a few years would become a dominant Internet retailer—had just sold its first book in 1995; auction site
eBay.com
was just a start-up company.
Netmarket.com
was in position to be the market leader (although it seemed implausible that members would pay the advertised $69.99 annual fee, given that introductory memberships were available for $1).

The merger seemed attractive to everyone. The combined firm—to be called Cendant—would have more than 35,000 employees, operations in 100 countries, and would be among the 100 largest U.S. corporations. Its shares would be worth almost $40 billion.
⁷
Walter Forbes would have 9.4 million stock options, worth more than $65 million, in a company that was better than his current one. Silverman would receive even more stock options, enough to bump his personal wealth above $100 million.

Most important for CUC, a merger with a company the size of HFS would give it the opportunity to use a new scheme to hide its rapidly building losses—permanently. CUC had just tried this scheme on a smaller scale, and it had worked beautifully. Here is how it would work: Cendant, the merged company, would record an expense called a
merger reserve,
to reflect the cost of the merger. Analysts would view the merger reserve as separate from operating expenses, and it would be listed separately in Cendant's financial statements. According to the analysts' models, Cendant's stock price was based on how much money it was expected to make in the future, and the one-time costs of a merger—such as legal expenses, banking fees, and severance payments—would not affect future operations.

The trick was to inflate the value of the merger reserve. Cendant could then draw from this inflated value to offset its accumulating operating expenses. Sure, the merger might look really expensive, but the analysts wouldn't focus on that. Instead, they would look at earnings, which would appear to be growing, smooth as ever.

In previous mergers, CUC had experimented with puffing its merger reserve, to great success. It wasn't rocket science. In one deal, CUC executives estimated the total merger reserve, and then simply doubled it.
⁸
CUC's Ideon reserve—which related to a merger with a firm called Ideon
Group, Inc.—was overstated by $135 million. By drawing on this reserve, CUC magically deflated its accumulating operating expenses by $135 million. With these mergers under his belt, Walter Forbes was looking for the “mother of all merger reserves,” a deal with HFS that would wipe out all of CUC's mounting expenses.

Unfortunately for Forbes, CUC never got the chance to use the merger-reserve trick again. Cendant was formed in December 1997, but, within a few months, HFS executives discovered what their due-diligence advisors had failed to uncover prior to the merger: that CUC had been a shell game. When Henry Silverman learned that CUC executives had been typing in their own versions of income and expenses, and abusing earlier merger reserves—and that therefore he might lose his hard-earned $100 million—he was understandably upset. None of the watchdogs supposedly monitoring CUC's managers had barked. That included the twenty-eight members of Cendant's unwieldy board of directors, half of whom had been directors of CUC. It included Ernst & Young, CUC's accounting firm. And it included three of the most prestigious investment banks: HFS had hired Bear Stearns and Merrill Lynch, and CUC had hired Goldman Sachs—and these banks undertook a due diligence investigation that lasted several weeks.

After learning of the apparent fraud at CUC, the directors on Cendant's audit committee immediately met to appoint an accounting firm to investigate. The directors needed a world-class group of auditors with an impeccable reputation and no conflicts of interest. Ernst & Young was out. The directors chose the accounting firm Arthur Andersen.

Andersen's accountants easily unraveled the fraud, perhaps because it was so basic, perhaps because they had seen similar schemes at other companies. In hindsight, it seemed obvious that CUC's earnings could not have been growing at such a rapid pace without a substantial amount of accounting puffery. But investors and analysts had focused instead on Walter Forbes's story about CUC's future on the Internet and the fact that CUC consistently beat earnings estimates. They hadn't probed the details until it was too late.

In April 1998, Cendant finally disclosed that it had discovered accounting “irregularities.” Its stock price fell by half, and then half again. Suddenly, a $40 billion company was a $10 billion company. In all, CUC had artificially overstated its earnings by nearly one-third.
⁹

Notwithstanding the limitations on securities lawsuits from 1995, more than seventy lawsuits were filed during the days after Cendant's
announcement, including eight lawsuits brought on behalf of purchasers of $1 billion of bizarre securities Cendant had just issued called FELINE PRIDES (more about them later in this chapter). Ultimately, these lawsuits led to the largest securities-fraud settlement ever: more than $3 billion.

Henry Silverman didn't fare badly, though. The money for the settlement came from insurance and from Cendant shareholders. In September 1998, the compensation committee of Cendant's board of directors approved a program to
reprice
the options held by executive officers of Cendant so that they didn't lose any money. For example, a 10-year option to buy stock for $40 a share was very valuable when the stock was at $40; it wasn't so valuable when the stock was at $10. But it would be valuable again if Cendant transformed it into a right to buy stock for $10 a share. By repricing the options, Cendant protected its executives from financial loss. Shareholders were outraged by the repricing. Why hadn't the board made up for
their
losses?

Cendant also took care of Walter Forbes, paying him a severance package of $35 million, plus $12.5 million worth of stock options. In 2000, Forbes was living the good life, developing the new Queenwood Golf Club, west of London, and raising money for a business called LivePerson, which provided Internet customer service and sales support.
¹⁰
Netmarket. com was still running years later, indistinguishable from about a million online buying guides, and still ostensibly charging $69.99 for a membership (although trial memberships were still available for $1).

Although CUC was not able to use the Cendant merger reserve to cover up its operating expenses, Forbes tried to use it as a slush fund to cover his own costs. He requested reimbursement for $596,000 of air-travel expenses for 1995 and 1996—travel that had occurred before the HFS merger was even contemplated—and noted that the expense should be charged to the reserve related to the HFS merger.
¹¹
Cendant's audit committee later found that Walter Forbes had overbilled his expense account by more than $2 million.
¹²