Detect accounting fraud, invest safely.

Welcome to the 127th edition of Festival of Stocks. The Festival of Stocks is a blog carnival dedicated to highlighting bloggers’ best articles on stock market related topics. This will include research and commentary on specific stocks, industry analysis, ETFs, REITs, stock derivatives, and other related topics.

I am proud to host the following selection of the best entries to the Festival of Stocks. As always, there are plenty of great articles submitted for this edition. Thanks to all the authors for sharing your articles with everyone. Enjoy!

Memorial Day Parade 2004 San Francisco by Alaskan Dude

Commentary

Steve Alexander presents 10 Red Flags in Financial Statement Filings - MagicDiligence posted at MagicDiligence - Optimizing Joel Greenblatts Value Stock Strategy, saying, “10 red flags to look for when examining a company’s financial statements. Conversely, the lack of these red flags usually indicates a well-run and transparent company.”

VC presents What To Invest In If The Economy Gets Worse posted at The Penny Daily, saying, “What to invest in if you think the economy is going to continue to deteriorate and unemployment will continue to rise.”

Qovax presents Options Backdating, Spring Loading posted at Value Investing and Entrepreneurship by Qovax, a Software Startup, saying, “Options backdating is one of the favorite shenanigans that executives can use to enrich themselves and employees instead of the shareholders. This is because backdating options is usually considered benign and not necessarily illegal as long as everything is disclosed to the shareholders.”

Dr. Barry Burns presents Making a Killing, or Getting Killed in the Markets? posted at Top Dog Trading, saying, “How to protect yourself when the market gaps dramatically against your position.”

Ironman presents Calling a Market Bottom posted at Political Calculations, saying, “When will the stock market hit bottom? Ironman at Political Calculations finds there’s a 36% chance of stock prices hitting bottom in February 2009 and a 24% chance it already happened in January 2009.”

jim presents Basics of Treasury Bonds & Securities Explained posted at Blueprint for Financial Prosperity.

Raymond presents Second Stimulus Check For Obama 2009 Economic Stimulus Package? posted at Money Blue Book.

NetBiz presents Understanding The Stock Market: How To Make Money Even In A Bear Market posted at Money Galaxy - Make Money | Save Money | Invest Money.

Silicon Valley Blogger presents Free Stock Charting Tool To Check Stocks, Chart Market Trends posted at The Digerati Life, saying, “Thank you!”

Sun presents Fibonacci Rule and How to Use it in Trading Gold Explained posted at The Sun’s Financial Diary.

Michael Cintolo presents The Lowdown on Value Investing posted at The Iconoclast Investor.

Insurance Toolbox presents How to Invest in the Stock Market without the Possibility of Losing Any of Your Investment posted at Fine-Tuned Finances.

Super Saver presents Looking for Future Winners instead of Past Performers posted at My Wealth Builder.

Patrick @ Cash Money Life presents Does Zecco’s New Rate Change Make You Want to Change Brokerage Firms? posted at Cash Money Life, saying, “Zecco essentially ended their free trades for many traders - here is how their new pricing structure compares to TradeKing and ShareBuilder.”

ChristianPF presents Zecco no longer free posted at Money in the Bible | Christian Personal Finance Blog, saying, “Apparently, even Zecco can’t keep the good thing going as the economic challenges continue…”

Stock Analysis

Saj Karsan presents Monster Worldwide posted at Barel Karsan.

Jae Jun presents Bill Ackman’s Wendy’s Presentation posted at Old School Value, saying, “Study the rationale for why Bill Ackman invested in Wendy’s”

Stockaholic presents Nova Chemicals (TSE: NCX) – Bankruptcy, Or A Screaming Buy? posted at Traders Corner, saying, “Is Nova Chemicals looking at bankruptcy or a turn around?”

Dividends4Life presents Stock Analysis: Lowe?s Companies, Inc. (LOW) posted at Dividends Value, saying, “Lowe’s Companies, Inc. and its subsidiaries operate as a home improvement retailer in the United States and Canada. The company offers a range of products and services for home decoration, maintenance, repair, remodeling, and property maintenance. Linked here is a detailed analysis commentary.”

One Family presents Our Fannie Mae (FNM) Investment – A Case Of Escaping With Minor Wounds! posted at One Family’s Blog.

Declan Fallon presents Zignals Stock Charts: British Airways posted at Zignals blog.

Daniel Nardello, former federal prosecutor, shares some tips on how to spot fraudsters like Bernard Madoff. Here’s a summary of things to watch for:

1. Carefully review investor materials including prospectus before investing.
2. Make sure you are absolutely clear about the fees you have to pay.
3. Do a background check for criminal records or litigations against the fund manager.
4. Find out how often the fund manager will report to you and in what reports will you get.
5. Verify the fund advisor is registered with the proper agencies such as SEC, FINRA or NFA.

Not a bad list at all. Some of the things mentioned in the list coincides with my 5 Red Flags of Fraudulent Hedge Funds. I talked about a few more red flags that are easier to spot.

Scam Trucks by jepoirrier

But, Harry Markopolos, in his testimony, said it took him just five minutes to identify Madoff’s scam. The biggest tip-off is the 45 degree graph depicting the consistent returns that Madoff claimed his funds were achieving. It’s just plain impossible. In fact, had SEC listened to any of Markopolos’ complaints back in 2000, 2001, 2005, 2007 and 2008, Madoff could’ve been caught earlier.

If you haven’t been following Madoff’s story, read What Madoff Can Teach Us. One thing is for certain — investors can not rely on any agency to protect them. As I’ve said before, the SEC can only stop the fraud after investors have lost their money. It is up to us to be able to tell the wolves from the sheeps. Read more on how to detect investment fraud.

Bernard Madoff’s funds have always been under close scrutiny because fellow fund managers are curious to the point of being suspicious as to how Madoff could have achieved such feat. Madoff did disclose to investors by simultaneously selling puts and buying calls while buying 30 - 35 blue chip stocks he could earn nominal returns in a short period. Rolling up these nominal returns over a one year period can yield fantastic results.

Tasked to duplicate Madoff’s success, Harry Markopolos, a former CIO of Rampart Investment Management, started his own investigation into Madoff beginning in 1996. After years of failed attempts to reproduce Madoff’s results, Markopolos was convinced that Madoff’s record of consistently outperforming the market 72 times in a row, to be precise, was simply impossible.

In May 2000, Markopolos sent the SEC evidence that would’ve implicated fraud at Madoff’s funds. But the SEC official who received the documents, Maeghan Cheung, had basically pooh-poohed the claims. Now that Madoff is exposed, Markopolos stepped up to identify shortcomings in the SEC that could’ve saved investors billions of dollars. Markopolos didn’t do so earlier out of fear for his family’s safety. This was well founded.

In his past life, before Madoff turned his focus onto his Ponzi scheme, he was the Chairman of NASDAQ. As Chairman, he championed the idea of greater transparency. To this extent, he worked very closely with the regulators. How close he was with the regulators was uncertain. The old adage “keep your friends close, but keep your enemies closer” seems to be in play here. Perhaps it was his reputation and public stand on greater transparency and accountability that had the regulators turn a blind eye.

What’s disturbing is it wasn’t just Markopolos who raised the alarm. Other rival money managers also attempted to duplicate Madoff’s returns to no avail. Complaints were filed with the SEC, but the investigations conducted were “inconclusive”.

The moral here is not to rely on the SEC to keep investors safe. The SEC can only react, not prevent. By the time the SEC can prosecute, the damage is already done. Prevention is better than cure, no? Learn how to identify the 5 Red Flags of Fraudulent Hedge Funds. Find out What Madoff Can Teach Us.

Forbes published an interview with Fred Joseph, Colorado’s securities commissioner and president of North American Securities Administrators Association yesterday on how to sniff out scams and fraudsters. On the same day, Shreveport Times published Diane DeCharles’ advice on doing due diligence to avoid investment fraud.

According to Mr. Joseph, 98% of the victims of investment frauds are senior citizens because they have accumulated sufficient wealth over a lifetime. And the problem is, as we begin to see during this recession, these Ponzi scam artists are legion.

Mr. Joseph thinks more Ponzi schemes and frauds are uncovered during tough times because more and more people are seeking guaranteed high returns. And that’s easy to sell despite the fact that “guaranteed high returns” is really an oxymoron.

But, let me offer another theory on why there’re more frauds reported during tough times. The reason is the fraud schemes are not sustainable. A Ponzi scheme that guarantees consistently high return is guaranteed to fail. In fact, the higher the return, the faster it falls. If you observe these fraud cases, they were started way before the recession. So people didn’t flee to the guaranteed high returns during recession. They were chasing guaranteed high returns when the economy was booming. In other words, we were greedy when we should have been afraid. The recession certainly helped make the fraud schemes fail faster.

Both articles chimed in on steps investors can take to protect themselves from fraud. The advice doled out echoes what I wrote in 5 Red Flags of Fraudulent Hedge Funds. Although, I don’t quite agree with DeCharles’ advice on diversifying. What if you are diversifying across all “guaranteed high return” funds? If you read 150 Stocks - The Secret to Proper Diversification?, you’d know why I agree with Warren Buffett when he said “Diversification is a protection against ignorance.”

Options backdating is one of the favorite shenanigans that executives can use to enrich themselves and employees instead of the shareholders. This is because backdating options is usually considered benign and not necessarily illegal as long as everything is disclosed to the shareholders. But before we can understand why options backdating has become so widespread especially within the technology industry, let us first examine how stock options work.

What Are Stock Options?

Stock options are rights to purchase shares of a company at a predetermined price. Traditionally, the exercise price is the same as the market price at the time of the option grant. The exercise price or strike price is the price at which the option can be used. Suppose you were granted a Microsoft stock option on January 30, 2009 which closed at $17.10/share. Your exercise price for the option will be $17.10. If the stock rises above $17.10 in the future, your option is said to be in-the-money because you can exercise it to immediately lock in a gain. So, let’s say the stock rose to $19.00 in June 2009. You can use your option to purchase a share for $17.10 instead of $19.00, therefore, locking in a gain of $1.90 or 11 percent instantly. However, if the stock continues to languish and drops below $17.10, your option is out of the money and is therefore worthless because you could buy the share at a cheaper price on the market.

As you can see, stock options can motivate the executives to increase the share price to enrich both themselves and the shareholders. Because of the vesting periods usually applied to stock options, they also help in retaining key employees. Stock options also provide a way for employees to share the profits with the shareholders.

The Problem with Options Backdating

Greed has a way of inspiring creativity. Executives began to exploit a loophole in the regulations surrounding stock option grants. Before the Sarbanes-Oxley Act of 2002 was passed, companies were allowed to report option grants two months after the actual grant date. This allowed executives to pick a two-month period where the stock price is the lowest at the beginning and the highest at the end, and grant the stock options at the lowest closing price. The result is stock options that are in-the-money from the get-go.

As I have mentioned before, this is not necessarily illegal as long as the intention to award such stock options are disclosed to shareholders upfront. Many companies, however, decided to keep this hush-hush. By doing this, they have caused two problems. One, they are not expensing the stock option grants properly thus misrepresenting financial statements to the public. Second, because they did not expense the stock option grants, they owe the Internal Revenue Service (IRS) employment taxes.

To the shareholders, the biggest lost usually comes when the options backdating scandal is exposed to the public. Shareholders will follow with civil lawsuits. IRS will sue for owed taxes. And worst of all, investors will lose confidence in the company and begin dumping shares. In the case of the most prominent case of options backdating in the tech industry, Brocade Communications had to recognize over $700 million in stock option expenses between 1999 and 2004. The stock plummeted between 2002 and 2007 and shareholders lost more than 70% of their investment.

The Temptations of Concealing Options Backdating

Locking in an immediate gain is not the only benefit from backdating options. Both the company and employee benefit from lower taxes by not reporting backdated options. Stock options that are granted at-the-money are considered to have no intrinsic value, and are therefore, performance-based compensation. (The intrinsic value of a stock option is the difference between the exercise price and the market value of the stock. So if the exercise price of an option is $8 and the market price is $10, then the intrinsic value is $10 - $8 = $2.) Since these options have no intrinsic value, the employee will not have to report them as income. But backdated options with locked-in gains have instrinsic value of greater than zero. As such, the employee must report this as income and will owe taxes. So, unreported options backdating can save executives a ton in taxes.

The Section 162(m) of the US Tax Code limits companies’ ability to deduct unreasonable compensation for executives beyond $1 million. So, creative executives began looking into stock options to avoid having to pay taxes. Since stock options are considered performance based compensation, they are inherently worthless at the time of grant. But backdated options do have intrinsic value at the time of grant. Again, by not reporting backdated options, the company owes taxes in employment taxes on backdated stock options granted to the employees. Don’t be fooled by Apple CEO, Steve Jobs’, Google CEO, Eric Schmidt’s and Yahoo! CEO, Terry Semel’s $1 salaries. Read Executive Compensation - What to Watch For.

Aside from the tax benefits above, executives also gain by misrepresenting the company as doing better than it actually is. When earnings meet or beat expectations every quarter due to under-reported expenses, investors reward the company with a higher share price. As a result, executives are granted more stock options and the cycle continues until the fraud is finally exposed.  Mercury Interactive, which flew high before it was finally known that ex-CEO Amnon Landan and other executives had been backdating options, traded in pink sheets before it was finally acquired by Hewlett Packard.

Executives’ Reaction When They Were Caught

Interestingly, executives’ first line of defense when they get caught was ignorance. They claim that the regulations and accounting rules surrounding options are so complex that no one can understand them. Legally, the prosecutor has to prove the executives’ scienter for a conviction. That is, the executives have to had known that it was illegal to backdate options to be responsible for the crime.

On the contrary, the accounting rules were clear, argued David Larcker, an accounting professor at the Stanford Graduate School of Business. He added, “They must have thought that the chances of getting caught were zero. For some of these companies, it must be hubris.” [1]

You have to wonder, “Why would the executives go through the effort of concealing options backdating if they didn’t think they were doing something wrong?”

Unfortunately, most of the cases of options backdating will remain concealed possibly forever. University of Iowa Finance Professor, Erik Lie, thinks there are two reasons for this. The first being, it’s very difficult to identify options that were backdated. Secondly, because options backdating was so rampant, the resources available to uncover all the cases are just insufficient. Most likely, the authorities will make an example out of the outstanding cases and move on. [2]

The Silver Lining

There is a bit of a good news that investors can rejoice over. With the Sarbanes-Oxley Act of 2002, companies must now report option grants within two business days instead of two months. The shortened period will effectively make options backdating very difficult. This is not to say options backdating will no longer happen. But the new rules will significantly curb options backdating. Microsoft practiced a variant called “forward dating” where the options are granted at the lowest price within 30 days after July 1st. But this is really backdating because you can’t know all the prices during the 30-day period until the 30 days have passed.

There are other tricks up the executives’ sleeves, namely spring loading and bullet dodging. Spring loading refers to the granting of options right before good news is announced to the public. Bullet dodging is the granting of options right after bad news is announced. Fortunately, these yield minor gains and probably not worth the effort.

References

1. Benjamin Pimentel, Backdating Probe Had Surprises for Investigators, MarketWatch, January 19, 2008.
2. Erik Lie, Backdating of Executive Stock Option (ESO) Grants, University of Iowa, 2006.

Side note: My recent post Executive Compensation - What to Watch For was featured on the Rich Life Carnival #30, the MoneyHacks Carnival–Frugalista Style!, the Cavalcade of Risk #70, and the Carnival of Financial Planning - January 31 2009 Edition. Be sure to check out the excellent recommendations in each carnival. Also, I highly recommend reading Jae Jun’s excellent tutorial on Analyzing Financial Statements: CROX Income Statement.