Caveat investor: trying to keep up with the market has some corporate execs cooking the books

National Review, April 21, 1997 by Gretchen Morgenson

A LITTLE bit of stock-market history was made February 11 when Centennial Technologies, a high-flying maker of computer memory cards with $40 million in sales, fired its chief executive, Emanuel Pinez, and its finance officer, James Murphy. At the same time, Centennial announced it was launching an inquiry into the accuracy of its financial statements, which were suddenly in doubt.

What made history about the Centennial announcement? Few on Wall Street could recall another time when so hot and widely held a stock fell to earth quite so quickly and resoundingly. Centennial was no obscure over-the-counter stock. Its shares were held by many mutual funds and professional money managers. In 1996, after the company's stock price quintupled, it earned the right to be called the top-performing stock on the New York Stock Exchange.

Today, Centennial's shareholders are singing a different tune. According to news reports, Centennial's chairman had boosted company revenues by selling empty metal boxes to companies he controlled and booking the sales as genuine orders for the company's PC cards. While the shares rang in the new year at 58 --20 times fiscal sales and 153 times reported earnings -- by the Ides of March they had fallen to 23/4, near their 1994 levels.

Although remarkable for its fall from grace, Centennial's situation is not an isolated one. As the stock market climbs ever higher, so too do the number of stories of stocks coming unglued because of financial irregularities. More and more companies, it seems, are resorting to cooking the books.

In just the first three months of 1997 we have seen these stories:

-- Mercury Finance Co., a maker of auto loans to high-risk borrowers, disclosed to investors that "accounting irregularities" had grossly overstated its profits in previous years. The stock, another high-flier, lost 80 per cent of its value.

-- Summit Medical Systems, a health-care computer-software concern, announced on March 4 that revenues of 1994 through 1996 were overstated by between 8 and 12 per cent. The stock slid to 37/8, down from a high of 261/2 in the summer of 1996.

-- Systems of Excellence, a maker of video-teleconferencing systems in Coral Gables, Florida, filed for Chapter 11 protection just weeks after its former chairman was sentenced to four years in prison for securities fraud and money-laundering. Charles Huttoe was charged with hyping the company's prospects to investors to inflate the value of his stockholdings. The company's stock --symbol SEXI --went from $4.50 in June 1996 to a recent 1 cent.

WHY was 1996 and the first few months of 1997, which was a fabulous time for stocks, also a fine time for frauds like these? You'd think that when the economy is cooking and stock prices are high, executives wouldn't feel the need to fabricate orders or sales to push earnings up. Wouldn't corporate insiders be more likely to resort to such tactics when stocks are in the doldrums?

Counterintuitive it may be, but bull markets in stocks beget bull markets in fraud. William McLucas, director of enforcement for the Securities & Exchange Commission, recently told an investment-industry conference that the stock market's climb to 7000 has led to a dramatic jump in stock-price manipulations. Especially vulnerable, according to the SEC, are investors who buy small over-the-counter stocks.

But as Centennial demonstrated, even shareholders in large, established companies can wake up to find their stocks in tatters following an announcement of trouble with the financials. Our advice: Caveat investor.

WHY more frauds now? First of all, because the stock market, to paraphrase Willie Sutton, is where the money is. But there's more to it than that. Today, corporate executives have compelling reasons to want their stocks in the stratosphere. And people whose business it is to get share prices up -- known in Wall Street lingo as promoters -- have more ways to do it than ever before. It is a happy confluence of events for the beneficiaries, if not for the unsuspecting shareholders.

Corporate bigwigs, for example, almost always hold large positions in their company's stock, which they can sell piecemeal, according to SEC rules. A rising stock price, therefore, has a direct, and possibly substantial, impact on their net worth. It is also very common nowadays for chief executives to have part of their compensation -- usually a bonus -- tied to their company's earnings performance, if not its stock-price moves. In any case, earnings drive stock prices. This can be a big incentive to make sure earnings are as high as they can possibly be.

Here's another: The millions of stock options that a corporate executive typically gets each year as part of his pay package become worth something only if the company's stock rises significantly in price from the time the options were awarded. And corporate chieftains also know well that it's easier to raise money in the stock market -- whether for research, development, or company expansion -- if their shares are hot than if they are cold.