Accounting crises can hit companies right where it hurts: their credibility. We discover how by talking to Waste Management, JDN Realty and MicroStrategy as well as accounting experts and IR consultants
When Charles Talbert, IRO at JDN Realty, began planning his wedding, he didn't budget time to return hundreds of phone calls from irate investors. But that's just what he found himself doing last February when it was discovered that top executives at his Atlanta-based company had been paying themselves unauthorized benefits. The resulting accounting headache took Talbert totally by surprise: 'I was not aware of the event until the morning of the press release announcement.'
Seldom does an IRO plan for a four-alarm corporate crisis. But now more than ever, companies are finding themselves in the awkward position of having to restate earnings because of an accounting error (an honest mistake), an irregularity (deliberate fraud), or a form of creative bookkeeping that falls somewhere between the two.
Accounting problems have plagued many big-name companies such as Waste Management, MicroStrategy, Cendant, McKesson HBOC, Bankers Trust, Livent, Rite Aid, Sunbeam, Thor Industries and Guilford Mills. A survey conducted by PricewaterhouseCoopers showed that 49 percent of securities claims were based on alleged accounting irregularities in 1999, up from 25 percent in 1997.
For an IRO unlucky enough to be embroiled in an accounting crisis, the principles of good investor relations apply: communicate honestly and openly, and when you don't know something, say so. 'Markets know how to handle bad news,' avers Michael Young, a partner at Willkie Farr & Gallagher in New York City and author of Accounting Irregularities and Financial Fraud. 'But markets work themselves into a frenzy in the absence of information.'
Investor relations officers who have experienced an accounting debacle firsthand learn to maintain a sense of humor. Cherie Rice, vice president of investor relations at Waste Management, kept a stack of rapidly-filled telephone slips as a trophy of sorts. 'I was getting 80 or 90 phone calls a day,' she recalls, 'and I saved that pile as a reminder of just how bad it can be.' And Talbert laughs as he recalls some of the wilder speculation on the internet chat boards; one rumor suggested that his honeymoon was merely a ruse to dodge investor inquiries.
A year after JDN's accounting crisis first hit, Talbert can look on the bright side: 'I feel fortunate that I had the ability to go through the process. I hope to never go through it again, but I've learned things. This is something that you read in a textbook.'
Never dodge
Accounting problems generally strike with little or no warning. In the case of JDN Realty, the board of directors wanted to prevent information from seeping out piecemeal and so kept everyone in the dark, including the company's IRO. 'It would have been helpful from my standpoint to have been involved earlier. It was a lot to digest in a short amount of time,' says Talbert. 'But I understand that the board was being very careful about what information they provided.'
The challenges of being suddenly thrust into the limelight are often exacerbated by high-level defections. At JDN Realty, the CEO, CFO, and head of development all resigned, says Talbert, so 'the people that investors normally would have talked to were no longer there. I was the only one left they would have talked to on a day-to-day basis.' Rice faced a similar situation. Waste Management restated earnings in 1997 because of an accounting problem and then a fresh round of accounting issues surfaced in 1999. Yet Rice says her biggest challenge was explaining why the CEO and CFO both quit on the exact same day in October 1997; the resignations were unrelated but the timing made investors understandably jittery.
Amidst a raft of other problems, IROs should expect their stock to plummet. According to Gary Zeune, founder of The Pros & the Cons, a consultancy and speakers bureau for white-collar criminals. 'There's nothing that creates volatility in your stock like loss of credibility. The market doesn't know how to value your shares.' Many companies lose around half their market value when an accounting problem comes to light. For dot-coms, the damage can be far more spectacular. Last spring, MicroStrategy's stock price plunged from $333 per share on March 10, 2000 to barely over $21 two months later.
Companies that want to talk their way out of their stocks' free fall need to be cautious, says Young. Although the legalese in which companies couch their investor messages can be offputting, it's usually necessary. 'Where accounting irregularities have surfaced at a company, communicating with shareholders can be a real challenge,' he acknowledges. 'On the one hand, you want to get shareholders truthful and accurate information about what has happened as quickly as you possibly can. The problem is, you're not sure what happened. What makes it worse is that it will take a long time to get to the bottom of things.' Young therefore advises hiring a specialized law firm and a forensic accountant to expedite the fact-finding process.
Although lawyers usually craft the high-level strategy, it's the IRO who communicates with Wall Street and retail investors, many of whom are bewildered, hurt, angry, and impatient for answers. Talbert recalls that while JDN Realty wisely chose to throw open its conference call to all investors, he now wishes the company had allowed a question-and-answer period. 'Even if we didn't have anything to say, we should have provided a forum for investors to get some things off their chests,' he says.
An IRO explaining an accounting irregularity has to deal with some raw emotions. Talbert recalls that most investors were surprisingly supportive, but 'some were angry and rightfully so. I gave them an opportunity to be angry.' He says it helps to remember that analysts and portfolio managers are in an awkward spot, too. 'They probably were being beat up. They were being asked questions by their bosses and they weren't getting answers.'
Your natural instinct, says Rice, is to retreat and say nothing, but IROs can't afford to disappear from sight: 'The worst thing is when investors feel like there's radio silence. It's horrible to get on a conference call and say there are things you don't know, but you have to get out there. They want to hear someone's voice.'
Although hiding is clearly the wrong strategy, most companies don't shine on this count, says IR consultant Anne McBride, chairman and CEO of the Anne McBride Company in New York City. 'I think most companies are afraid. In a market as volatile as the one we're in, I can understand that.'
MicroStrategy, which is in the midst of an SEC investigation for having allegedly inflated sales and profits through its accounting methods, has been criticized for violating 'all the most basic rules of corporate crisis management,' according to a June 5, 2000 Washington Post article in which company founder Michael Saylor was compared to a deer caught in the glare of headlights. Bill Chatterton, who heads IR for MicroStrategy, seemed no savvier in March when he promised to return repeated calls for this article and didn't. On two separate occasions, he hurried off the phone, saying that the situation was 'just so sticky.'
According to the experts, the only strategy worse than ducking questions is compounding the first error with a second one. 'If something surprises you,' says Rice, 'it's always natural to want to make your best estimate of what an answer's going to be, but sometimes you have to say, We just don't know.' Rice speaks from experience since Waste Management issued a quarterly earnings pre-release in 1999 and then had to revise the numbers downward three separate times before announcing final numbers.
Defending yourself
Not all accounting errors arise from deliberate misdeeds. Phillip Stocken, assistant professor of accounting at the Wharton School of the University of Pennsylvania, says that 'new economy companies are very complex' from the standpoint of revenue recognition (the policies a firm uses to decide when a sale is entered on the books). 'Oftentimes,' he says, 'it's not altogether obvious what a firm should be doing,' and therefore most accounting problems - like those at MicroStrategy - have to do with a company's revenue recognition policies.
Willkie Farr & Gallagher's Young believes that companies are experiencing more accounting problems today out of a frenzied desire to meet analyst expectations. Stocken agrees: 'Senior managers are pressuring managers to meet their targets, and sometimes if they don't have the natural growth, they resort to accounting shenanigans.'
Creative accounting is, of course, nothing new. Michael Watras, president and CEO of Straightline International, a Manhattan-based strategic and branding consultancy, suggests that more of these problems are coming to light now because 'the technology allows people who cheat to be caught.'
Finally, everyone points out that the consequences of an accounting problem - both legally, and from the perspective of a company's market value and reputation - have never been more dire. 'If you publish a press release announcing an accounting irregularity, you can bet the ranch that you'll have class action lawsuits, and a couple of horses that you'll have an SEC investigation,' says Young. Recently, the SEC has even begun referring some of its major accounting inquiries to the US attorney's office for formal criminal investigation.
Companies slapped with class action suits usually wind up paying shareholders since management has already publicly admitted that it misstated a material fact. Young notes that negotiated settlements can range from as high as a few billion dollars (on December 7, 1999, Cendant announced it would pay shareholders $2.83 bn) to much smaller sums for companies already in dire financial straits. Often, the independent auditors are sued, too. On December 21, 1999, Ernst & Young agreed to pay a $335 mn settlement with Cendant shareholders. And PricewaterhouseCoopers is reportedly under investigation by the SEC as part of the widening probe of MicroStrategy.
From an IRO's perspective, a stepped-up investigation can be a good thing, the first move toward ending controversy. Talbert of JDN Realty recalls that when the SEC announced its investigation had progressed to the 'formal' stage, the news came as something of a relief. 'We didn't always want to be under the spotlight of informal waiting to go to formal. Now there can be some closure.'
Rebuilding trust
Of all the tasks facing a company with an accounting scandal, the most important is re-establishing trust. Studies have shown that markets respond negatively to earnings restatements even when earnings are revised upwards. That, argues Stocken, is proof of just how highly investors value the competence and overall trustworthiness of a company's management. All earnings restatements, he says, 'raise questions about the firm's system of internal control that executives use to manage the business. There's some question about the competency of management and how well they know their business.'
As the first step in rebuilding credibility, Anne McBride advises companies to make a clear disclosure about what has happened - without dwelling unduly on the problems. 'Make the statement, have a conference call, and put it to bed. I don't think that companies should be profusely apologetic,' she says. 'You have to say, We made a mistake, and here's how and why, and then move on.'
Another strategy is to help investors put problems in perspective by reminding them of the overall strengths of the business. Although undeniably serious, an accounting problem is not nearly so disastrous as a pharmaceutical company learning that its main drug has harmful side effects or a manufacturer losing the largest of its three key customers. Rice advises IROs to 'find the things that you can focus on that are good. For example, with Waste Management, one of the things that we told people was that we're a decentralized company with 1,000 units across the US, and our people were out there picking up the garbage and disposing of it safely every day.'
In the what-doesn't-kill-you-makes-you-stronger camp, David Folger, a VP covering the high-tech industry for Meta Group in Pleasanton, California, believes that MicroStrategy is changing for the better because of its current woes. 'That company has the can-do spirit taken to an extreme. [The SEC investigation] has made them come back to earth and be more focused,' he says. 'In the long run, it could be good for them, but they'll have to make it through the short run.'
Once lost, trust isn't regained overnight. 'It can take a long time for [an accounting problem] to go away,' concludes Straightline's Watras. 'Analysts have very short memories, except when it comes to this type of thing.'