Corporate Misconduct At Work Against Investors: Six Varieties
No investor – whether new to investing or with years of experience – is immune from corporate misconduct. Greed, defined as an uncontrolled longing to acquire or possess more than what one needs, is the drive that causes corporate executives to make decisions that serve their own interests and violate the duties owed to shareholders. This behavior often results in substantial financial losses for both the company and its shareholders. In 2020, shareholders lost $245 billion due to corporate misconduct. Some of the most common types of misconduct include the following:
- Accounting fraud
- Fraudulent statements
- Insider trading
- Pump-and-dump schemes
- Violations of the Foreign Corrupt Practices Act (FCPA)
- Conflicts of interest
Unfortunately, it’s not easy to spot the misconduct, which often goes unfettered until after the damage is done. When the executives are no longer able to keep their scheme a secret, the truth comes out and the stock declines. Nevertheless, armed with the right information, you can identify possible red flags to inform your investment choices. Robbins LLP advises and represents shareholders who have been harmed by these forms of misconduct, which are discussed below.
Accounting fraud is the intentional manipulation of financial statements, which happens when corporate executives misdirect funds, overstate revenues, understate expenses, overstate the value of corporate assets, or underreport liabilities. Executives engage in accounting fraud to manipulate earnings to meet analysts’ forecasts, secure investors’ interest, obtain bank approvals for financing, meet debt covenant restrictions, achieve bonuses, or artificially inflate the stock price. Accounting fraud usually goes hand in hand with weak internal controls.
Enron Corporation’s rapid decline in 2001 is the most widely known instance of accounting fraud. Enron, a company dealing in electricity, natural gas, and other industries, claimed revenues of almost $101 billion in the year 2000. At the end of 2001, it became apparent that Enron’s reported financial condition had been propped up by institutionalized and systematic accounting fraud. Many of Enron’s recorded assets and profits had been artificially inflated; some were completely fraudulent or did not exist at all. Simultaneously, Enron failed to report many of its debts and losses. It turns out that Enron’s executives had been well aware of the financial manipulation, using special purpose entities and offshore accounts to line their pockets, while hiding the company’s true value from investors.
Red Flags Pointing To Possible Accounting Fraud
The best way to assess whether there is accounting fraud is to look at a company’s financial statements.
- Is the company experiencing sales growth while its competitors are struggling?
- Did the company report significant growth at the end of its fiscal year?
- Are all documents accounted for?
- Do you see excessive adjustments indicating attempts to hide fraud?
How is the company’s internal corporate governance? Weak governance increases the likelihood of fraud going unchecked. Fraud is also more likely when a company’s management compensation is derived from bonuses based on short-term targets.
The Securities Act of 1933 and the Securities Exchange Act of 1934 prohibit making fraudulent statements in connection with the offer and sale of securities. Misstatements can occur in a company’s communications, including the following:
- Registration documents: All U.S. publicly traded companies must be registered with the U.S. Securities and Exchange Commission (SEC)
- Annual and quarterly reports: Companies with more than $10 million in assets whose securities are held by more than 500 owners must file reports with the SEC
- Analyst calls, press releases and other types of publications meant to encourage investors to purchase shares of stock
Companies may issue fraudulent statements regarding their financial statements and business prospects. Companies may also make industry-specific statements. Examples include:
- Pharmaceutical companies issuing false or misleading statements about the success of new drug trials
- Schools misstating job placement and student loan repayment rates
- Hotels making false statements regarding database breaches
- Mining companies making false claims regarding the quality of their mining operations and volume of production
Red Flags Indicating Likely Fraudulent Statements
- Look for incomprehensible or convoluted language and generalities unsupported by specific facts, hard-to-find numbers, and a failure of executives to provide detailed explanations. On conference calls, do executives repeat questions as a stall tactic or avoid questions altogether?
- Does your company consistently meet or beat analysts’ expectations? Every company has its ups and downs; if your company never has a down quarter, there may be a problem.
Insider trading is the trading of a public company’s stock or securities in breach of a fiduciary duty or another relationship of trust or confidence based on material nonpublic information. Insider trading takes two forms: buying securities prior to the company announcing good news (such as unexpectedly high quarterly earnings) and selling securities prior to the company announcing bad news (such as the company’s failure to obtain a new drug application). One of the most infamous cases of insider trading involved Martha Stewart. Stewart held an investment in ImClone, which was expecting great things from its cancer drug, Erbitux. When the FDA announced it would not approve the drug, the stock declined 16%. Just days before the FDA announcement, Stewart sold her investment for a nearly $250,000 profit. It was discovered that Stewart’s broker, who was also the broker for ImClone’s CEO, tipped Stewart off that ImClone’s CEO had placed orders to sell his and his daughter’s shares of ImClone in advance of the FDA’s rejection of Erbitux. By selling when she did, Stewart avoided losses of over $45,000.
Red Flags Of Insider Trading Practices
- Insiders trying to avoid tipping off the market will often sell small lots in large volumes instead of selling large amounts of stock at once, though this can happen as well.
- Consider who in the company is selling stocks. CFOs or CEOs are important to watch as they are the most knowledgeable about the financial details of the company, but if middle managers are also selling, that’s telling of a rampant issue taking place.
- Be cautious of stock tips, because acting on inside information is a crime.
Promoters of pump-and-dump schemes coordinate rumors, misinformation, or hype to artificially increase interest in stocks to drive up the price. As demand and trading volume increase, the inflow of investors leads to a sharp rise in stock price. Once the price of a stock rises, the promoters sell the stock for short-term gains. Pump-and-dump schemes usually target micro- and small-cap stocks, as they are easy to manipulate. When the stock price falls after the dumping occurs, individual investors sustain great losses. A popular example of pump-and-dump schemes is in the film “Wolf of Wall Street.” Brokers pumped up stock prices by selling stock in large volumes to customers. Once the buying stopped, the brokerage firm dumped its shares and reaped a large profit. The stock price fell, resulting in big losses for those customers because they did not sell their shares in time.
Red Flags Alerting Investors Of Pump-And-Dump Activity
- Be wary when you receive notice by any means of communication that a stock is about to soar.
- Be especially careful when such notices contain exaggerated claims and do not acknowledge risks.
- Do not succumb to claims that the investment will make “INCREDIBLE GAINS,” is a “BREAKOUT STOCK PICK,” or comes with a promise of guaranteed returns.
Violations Of The Foreign Corrupt Practices Act
Violations of the Foreign Corrupt Practices Act (FCPA) occur when companies issuing stock in the U.S. bribe foreign officials in exchange for obtaining or retaining business and when foreign firms cause an act in furtherance of a corrupt payment to occur within the territory of the U.S. The FCPA requires companies to record assets with transparency to prevent masking corrupt payments and maintain internal controls to ensure that business transactions are properly accounted for. The FCPA is enforced by the Department of Justice (DOJ) and the SEC. Violators are subject to criminal charges, which may lead to imprisonment or fines and penalties of up to $500,000 or the amount by which the entity profited from the offense. Recent examples of FCPA violations have included charges against Ericsson and Walmart Inc. as follows:
- Ericsson (NASDAQ:ERIC) was penalized for using bribes to get money in the hands of government officials internationally. Ultimately, Ericsson agreed to pay penalties of more than $1 billion to the SEC and DOJ.
- Walmart Inc. was held liable for violating the books, records, and internal accounting provisions of the FCPA by failing to operate a sufficient anti-corruption compliance program. Walmart Inc. agreed to pay the SEC and DOJ more than $282 million in penalties.
Red Flags Of FCPA Violations
When researching a company, note whether any of the following warning signs are true:
- The company or its industry has a history of FCPA issues
- It does business in countries that have a reputation for corruption and bribery
- It previously misstated its financial records
- It is intertwined with multiple shell companies
- It has relationships with government officials
Conflicts Of Interest
Conflicts of interest occur when a corporate executive or board member chooses personal gain over their duties to the company and its stockholders or otherwise exploits their position for personal gain. Examples of conflicts of interest include the following:
- Receiving personal gifts
- Taking actions to benefit one’s personal business
- Showing favorable treatment to family or friends
- Collecting confidential information to the detriment of the company
- Accepting a transaction from another organization that benefits the executive but harms the company and its shareholders
In a much-publicized botched IPO attempt, WeWork’s public offering paperwork revealed numerous deals the company had engaged in involving the family members of CEO Adam Neumann and his wife, Rebekah. But, WeWork failed to disclose conflicts involving the family members of numerous other employees, including the parents of the vice chair and the brothers of its co-head of real estate and chief real estate development officer.
Red Flags Demonstrating Conflicts Of Interest
- Allowing one person to hold the combined role of CEO and chairperson often leads to conflict issues as this position can be used to sway other board members.
- A lack of independent outsiders – people unrelated to key employees, have never worked at the company, and have never worked for a major supplier, customer, or service provider of the firm – could indicate a problem.
- Consider whether the company is run like a “family business,” in which various family members benefit from a board member’s position. If so, this may be a red flag worthy of careful attention.