INCOME STATEMENT ISSUES Revenue Recognition

Revenue Recognition Issues Barry M Frohlinger copyright 1981 - 2016 page 1

INCOMESTATEMENTISSUESRevenueRecognition

Objective:

Theattachedreadingsprovideanopportunitytoreview

numerouscompanieswhohavemanipulatedearningsthroughrevenuerecognition1.

Prepare the table on the subsequent page with the following summary of: a. Time of revenue recognition b. Altered behavior (as a result of timing of revenue recognition) [i.e., how did management behave differently from normal]

1 When it comes to revenue recognition, FASB says : "revenue recognition is the largest single category of fraudulent financial reporting and financial statement restatements."


Company Time of Revenue Recognition

Altered Behavior

Datapoint

Global Crossing

Bausch & Lomb

Media Vision

Lernout & Hauspie

Regina

RJR

ZZZZ Best


Datapoint

Awell-timedlookatfactoryloadingdocksmighthavespottedthetroublebrewingatDatapoint,aone-timeWallStreetfavoriteamonghigh-technologycompaniesthatfellunexpectedlyonhardtimes.Neartheendofsomefiscalquarters,dockworkersatSanAntonio,Texas,thecompany'sheadquarters,wouldtollovertimetorushoutshipmentsofDatapoint'scomputersandtelecommunicationsequipmentbeforetheperiodended,pausingonlytoeatMexicanfoodprovidedbythecompany."Youalwaysknewiftheypushedyourorderthroughrightbeforethedeadlinebecausetheboxeswouldhavetacosauceandbeerstainsonthem"aCaliforniadistributorsays.Thatsortofhelter-skelterscenewasafarcryfromthepublic'simageofDatapoint,whichhadbuiltasterlingreputationforshrewdmanagement,tightinternalcontrolsandsteadygrowth.Butthefactisthatdistributorssawalotofthoserush-rush,end-of-the-periodshipmentsinrecentyearsaccordingtoanumberofpresentandformerDatapointexecutives,employeesandcustomers.Datapoint'smanagementwasbentoncontinuingastringofrecordprofitsthatwouldfinallycover39consecutivequarters.Becauserevenuescanberecordedassoonasproductsareshipped,thedeadlineshipmentsofferedahandytoolforbeefingupquarterlyresultsatthelastminute.Infact,thosehurry-upshipmentsareakeytounderstandinghowahigh-flyingcorporatestarlikeDatapointcouldshinesobrightly,thendimsosuddenlytorecentweekstoahailstormofnewsaboutfinancesetbacks,possiblyshakybookkeepingandexecutivedepartures.Whatemergesfromdozensofinterviewsisapictureofacorporatemarketingstaff,underconstantpressuretoboostsales,resortingtoincreasinglyquestionablemeasuresthatultimatelybackfired;shippingtocustomerswhohadn’tyetmetDatapoint’sowncreditrequirement,usingtheirownmoneytopaywarehousingfeessothatdistributorswouldacceptshipmentstheydidn'thaveroomfor;evenshippingtoanimaginary"JoeBlow"inoneinstance,justtogetproductsoutthedoorbeforeaquarterended.Itwasacombinationof"wishfulthinkingandthenotionthatweweresogoodatmarketingthatwecouldkeepongrowingnomatterwhat,"saysaDatapointmarketingemployee.Datapoint’srecordofferedsomereasonforbelievingthat.Aftergoingpublicin1970,itfirstshowedaprofitin1973,theyearHaroldO’Kelleybecamechiefexecutive,whenpostednetincomeof$2milliononrevenueof$18.6million.Defyinganindustrytrendofbuildinglarge,centralizedmainframecomputers,Datapointsawsalesofitssmallstandalone"disperseddataprocessing”systemstakeoffthroughtherestofthe1970’s.Salespeakedat$396millionforfiscalyear1981,generatingnetincomeof$49million.Alongtheway,thecompanyneverpostedadeclineinquarterlyearnings,muchlessalossandthepriceofitsstocksoaredto$67ashare,withamarketcapgreaterthan$1billion.Thecompany’slineofproductsexpandedfromsmallwork-stationcomputerstoincludemulticomputernetworkstelephonesandswitchingsystemsandmostrecently,whatitcallstheintegratedelectronicoffice,whichcombinesbothcomputersandtelecommunications.Butthebubbleburstearlyin1982.UnexpectedflatearningsforthesecondquartercoupledwithDatapoint’sannouncementafewweeksagothatitprobablywillpostalossforthethirdquartersentthestockplummetingtoaslowas$12.Thecompanyannouncedthatitmightreverseasignificantnumberofsalesrecordedasrevenueinthethirdandpossiblypriorquarters.Subsequently,fivekeymarketingofficersleftDatapoint,aninsidedirectorwasdemoted,andtwooutsideauditingfirmsandapackoflawyershavebeencalledintogooverthecompany'sbooks."Datapoint’sactionsimplytomeamajorbreachofpolicyinthemarketingdivision”saysMichaelFaherty,whointhemiddle1970’swasDatapoint’schieffinancialofficerandamemberofitsboard.TheinternalinvestigationbyPeat,Marwick(Datapoint'sregularauditors),PriceWaterhouseandtheattorneysfocusesonDatapoint'saccountsreceivable[uncollectedbutrecordedrevenuesfromcomputerequipmentpreviouslyshipped].ThecentralissueappearstobewhetherDatapoint'smarketingdivisionrecordedasrevenuestransactionsthatweren'tcertain.AccordingtoDavidPearcetheformervicepresidentandcontrollerofthemarketingdivisionwhowasaskedtoresign,"Webegannoticinglastwinterthatmoreequipmentwasbeing


returnedorrepossessed."Whathappened,hesays,isthatDatapoint'slargedistributorshadbeenloadedupwithbigshipmentsattheendoffiscal1981,allowingDatapointtorecordthoseshipmentsasrevenueseventhoughpaymenthadn'tbeencollected.Butthen,inthefirstandsecondquartersoffiscal1982,severalofthedistributors(calledOEMs,ororiginalequipment-manufacturers)eitherwentbrokeorquitthebusinessasaresultoftherecession,poormanagementorproblemspayingbills.ThatwasalarmingtoDatapointforseveralreasons.Fromanaccountingpointofview,itaddedtoagrowingpileofproblemreceivablesatthecompany.Andwhenshipmentsaren'tacceptedorthecustomercan'tpay,revenueshavetobehedgedbybad-debtexpense.Beyondtheaccountingcomplications,ithadalsobecomeclearthatDatapoint'smarketingpeoplewereusingquestionablemethodstoconvincedistributorstotakeshipmentstheydidn'thavespaceorcustomersfor.Somewereregularlypayingfreightandwarehousingbillsnormallypaidbydistributorsthemselves.Andoneformermarketingrevenuespecialist-saysheusedcompanymoneyfromexpenseaccounts,aswellas$185ofhisowncash,topaywarehousingexpensesinNovember1980forOlympiaDataSystemsInc.,adistributorbasedinNashville,Tenn.(HeleftDatapointafterthecompanycaughton).InFebruary,DatapointitselfreluctantlyassumedoutstandingobligationstopaywarehousingfeesthenbannedmakingsuchpaymentsattheendofApril.Olympia,oneofDatapoint'sstrongestdistributors,confirmsthatthepaymentsweremadebutsaysthatitiscurrentlypayingallitswarehousingexpensesonDatapointequipment.Oncelargedistributorsacceptedthebigshipments,theyhadtofindcustomersforthem.SeveralDatapointmarketingmanagershelpedformorethantwoyearsonthatscoretoo,byallowingthedistributorsto"broker"equipmenttoother,oftensmallerindependentDatapointdealerseventhoughcompany-policyprecludessuchpractices.(Brokeringisthesellingofcomputerequipmenttoanotherdealerwithoutfirstdoingsomethingtoincreasethevalueandsellingprice-supplyingprogramsandrepairservices,forexample,orevenphysicallymodifyingtheequipment.Manufacturersdiscouragebrokeringbecauseitcanundercuttheirowndirect-salesforces.)Byencouragingbrokering,themarketingmanagershelpedlargedistributorsclearouttheinventorymorerapidly,andthat,inturn,openedupspacetotakeevenlargershipmentsfromDatapoint,especiallyneartheendofaquarter,whengenerousdiscountsandpaymenttermsalsowereoffered.ButdumpingallthatcomputergearondistributorsalsocreatedmorecompetitionforDatapoint'sownsalesmen,andsomeotherregionalmarketingmanagersdidn'tlikeit.InDecember1981,oneofthosemanagerswroteStephenJames,thenvicepresidentforsales,complainingthat"brokeringisnowsowidespreadthatalmosteveryenduserknowswheretheycangetDatapointgearatalowercost.Thesituationisdemoralizing."Mr.James,whowasoneofthefivemarketingexecutiveswhorecentlyresignedrepliedinacrypticmemothat"weareawareoftheproblems...inthemeantime,ceaseyourcounterproductiveactions."Apparentlyhemeanttheletter-writing.InFebruary,Datapointclampeddownonbrokering,althoughitstillgoesonamongsomeofitsdistributorsandthroughouttheindustry.Perhapsthemostbizarreexampleofhurry-upshippingoccurredlastsummer.Ithappenedbecauseofafrequentlyoccurringdilemma:Adistributorwasn'treadytoaccepthisshipmentofcomputerequipment,yetitneededtobemovedsothatrevenuecouldbeloggedinaparticularquarter.Thesolution:Theshipmentatruckloadofcomputerswasaddressedto"JoeBlow"andsenttoahotelonSouthPadreIsland,Texas.Therevenuewasrecorded,andbythetimetheerrantshipmentwasstraightenedoutandforwardedtothepropercustomerinDallasseveralweekslater,hewasreadytoacceptit."Thatwasridiculous,really,"saysMr.Pearce."Ourshippingordersrequireanameandanaddress,andsomebodyenteredinafictitiousnameandarelatedcustomer'saddress,andwassurpriseditwentallthewaythrough."Therearemorerecentexamplesofbendingcreditandshippingcriteriatoallowearlyshipmentsbeforeaquarterended,formerexecutivessay.Customarily,anorderhadtopassarigorouslistofcreditchecksbeforeitwouldgetapprovaltobeshippedincludingwrittenconfirmationbylenders,orotherproofsofcredit-worthinessprovidedbycustomers.ButStevenHaber,whountilrecentlywasdirectorofcorporatecreditcollections,concedesthathesometimesused"creative"methodstogetaroundcreditholdsplacedonparticularorders-bytelephoningcustomers'lendersforverbalapproval."Thebankssometimesplannedonclearingthedealmaybefivedaysorsoafteraquarterended,andifIknewthat,I'dletitship."Mr.Habersays."Veryrarely,infactalmostneverdidtheshipmentscomeback."Othermarketingexecutivessayshipmentssometimeswereapprovedevenifitwasknownthatacustomer'sloanwouldn'tcomethroughuntilwellintothenextquarter,inotherinstances,however,Mr.Haberandother


marketingofficerswouldadheretocreditcriteriaandholdbackshipmentonlytofindlaterthatasuperiorhadgiventhegreenlighttoship."IremembergoinghomeonaFriday-thinkingwehadmissedshippingbytheendofthequarter,onlytofindoutonMondayorTuesdaythatsomeonesentitonthrough,"recallsaformermarketingrevenuespecialist."Thatkindofapprovalcouldonlycomefromavicepresidentinthemarketingdivision."Attimes,customersweren'tevenexpectingtheirshipments.''Wewouldsendasalesmantositwiththecustomerwhentheshipmentrolledinandconvincethemtogoaheadandacceptit"saysMr.Pearce.ThosepracticesapparentlycontinueduntiltheendofDatapoint'sthirdquarteremployeessay."It'scrazy,theorderstheyaskedustotake"saysFredGottliebpresidentofBristolInformationSystemsInc.,ofFallRiverMass.Datapoint’soldestOEMdistributor.MrGottlieb,whoorganizedtheNationalAssociationofDatapointOEMssayshegotsofedupthatherecentlyquitsellingDatapointequipmentinlargequantities.Assessingtheblamehowallthiscouldhappenisoneofthequestionstheinternalinvestigationwillattempttoanswer.Recentfiringsseemtopintheblameonfivemarketingexecutives.ThedemotionofRichardPalermo,formerlyadirectorandexecutivevicepresidentforoperations,toavicepresidency,alsoassumessomesignificance.Buttherearemanyothertheories.Someinsiderssaytheboardoverreactedoutofembarrassment,whileothersbelieveitdidn'tlookhighenoughamongDatapointexecutivesforcensure.Stillothersblametheabsenceofafull-timechieffinancialofficer.AfterJosephG.Degenresignedthepostinthespringof1981,Mr.O'KelleyandEdwardGistaro,thecompany'snewpresident,tookturnsactingaschieffinancialofficereventhoughneitherhasafinancialbackground.(Mr.O'Kelleyisanengineerbytraining;Mr.Gistarohasanengineeringandmarketingbackground.)Moreover,bothcurrentandformerexecutivessaythatDatapoint’sboardauditcommitteehadn'taskedforacompleteupdateonreceivablessinceJanuary1981,andthatthecompany'sauditors,PeatMarwickdidn'tpaymuchattentiontoreceivableseither."Corporatefinancepeopledidn'tspendmorethananhourinmyofficethewholepastyear,"assertsMr.Pearce,theformermarketingdivisioncontroller."Andtheauditorsneveraskedverymanyquestions."AnattorneyforPeatMarwickreplieshowever,thattheaccountingfirmprovidedfull,completeandexcellentauditing,andthatincludesthereceivables."Meanwhile,theeconomysoured,directsalestoend-usersdroppedoff.Salesabroadslumpedfurtherandabloatedsalesforcedoubledtomorethan500bytheendoffiscal1981-wasn'tpullingits–weight.Tomakesalesmattersworse,newDatapointproductsweren'tkeepingupwithcompetingequipment,andfullproductionofnewtelecommunicationssystemswasrunningnearlyayearbehindschedule."Bythattimequarter-to-quartergrowthhadbecomeareligionatDatapoint,anditwaseithersellorgetfired,"saysonecurrentregionalmarketingmanager.SoDatapointmarketingpeoplepushedthroughshakierandshakierorders.ByJanuaryof1982,thereceivablesproblemsstartedgettingworse.ItwasFebruaryorMarchbeforeweknewwehadbigproblems,"Mr.Pearcerecalls,"andwefinallystartedtalkingseriouslyaboutsettingsomestrongershippingcriteria.ThatsquareswithMr.Gistaro’sApril30statementthattopDatapointexecutivesrecognizedseriousreceivablesproblems"twoorthreemonthsago,"andwithMrO'Kelley'sannouncementinlateFebruarythatthebacklogwasbeingscrutinizedintheclosingweeksofthethirdquarter.However,itwasbecomingclearthatDatapointshard-pressedsalesforce,whichhadbeenparedbyathirdinasurprisemoveinlateMarch,wasstillloggingordersthatmightnotholdupaftershipment.Mr.Gistarodeclaredwhathecalledathree-week"amnestyperiod”duringwhichscheduledshipmentscouldbetakenoffthebooks,noquestionsasked.Butitwastoo-late.Shipmentsfrompreviousquarterswerestillcomingbackraisingquestionswhetherthecompany’sbaddebtreservewouldcoveritall.Mr.Gistaro,whoonlyinFebruaryacknowledgedtosecuritiesanalyststhat"maybewe'vebeenpushingoursalesmentoohard”realizedthatasignificantamountofrecordedrevenuesmighthavetoberolledback.That,combinedwithwretchedlegitimatesalesinthethirdquarter,wouldresulttoDatapoint’sfirstnetlossinadecade,thecompanyacknowledged.NowDatapoint’sboardanditsteamofinvestigatorsaretryingtopickupthepieces.Oneformerexecutiveclosetotheinquiryestimatesthatauditors,whohavebeen"kickingovereverystonepossibleprobablywon'tturnupmorethan$10millioninreversiblerevenues,althoughtheymightpadthenumberjusttobesafe"(Revenuetotaled$268.3millionforthefirsthalfoffiscal1982.)Meanwhile,stricterinternalaccountingstandardshave"decimatedthebacklog,"accordingtoMr.Pearce,and"putonhold",dozensofothershipments.Itisn'tclearwhetherresultsfrompreviousquarters,andperhapsfiscal1981,willhavetoberestated,althoughMr.Gistarohassaidhedoesn'tthinkso.If1981figuresdorequire,adjustments,though,thefalloutcouldreachbeyondDatapointtoPeatMarwick.Already,ithasbeennamedasacodefendantinseveralof


themorethanadozenshareholderlawsuitsfiledagainstDatapointanditsboard.ThoselawsuitsaccuseDatapointmanagementofamongotherthingsprovidingfalseandmisleadinginformationaboutDatapoint'sfinancialperformanceinrecentquarters.AlsolistedasacodefendantinatleastonesuitisKidderPeabodytheleadingunderwriterofDatapoint's$100milliondebentureofferduring1981.Kidder,Peabodydeclinedcomment.Beyondthefinancialproblems,Datapointsrecentmanagement"facesatoughjobrebuildingitscredibility"contendsEricWell,anindustryanalystforMorganStanley.HesaysDatapoint'smanagementnowhasthereputationof"runningastraybymakingemotionalandegotisticaldecisionsbasedonthecompany'sperceptionandperformanceonWallStreet."Moreover,otheranalystsassertcustomersarebeginningtoquestionwhethertheywanttoinvestincomputerequipmentmadebyatroubledcompany.NobodyispredictingthatDatapointwillgo,underasaresultofitsproblems,butmanyanalystsdidn'tthinkMr.O'KelleyorMr.Gistarowillsurvivedespitethefiringsofkeymarketingexecutives."Managementhasventeditsspleen,andaftertheresultsoftheauditarereleasedtheboardwillwanttoventitsspleen,"predictsoneanalyst.AformerDatapointexecutivebelievesthatthehurriedanddrasticmeasuresalreadytakentorestorethecompany’simagedemonstratehowseriouslytheboardperceivesitsproblemstobe,evenbeforetheinternalinvestigationiscompleted.Atthispoint,hesays,"anything,nomatterhowsmall,becomesmaterial."

end


GlobalCrossing

Inearly2002,theSECaskedtheBermuda-basedtelecommunicationscompanyforcorporatedocumentsandalettersentbyaformerfinanceexecutivethatraisedconcernsthatGlobalCrossinganditsauditor,ArthurAndersen,weremisleadinginvestors.

Insuchinvestigations,theSECtriestodeterminewhetheraccountingruleswereviolated.Ifitfindsevidenceofpossiblewrongdoing,theSECwillopenaformalinvestigation,whichinturndetermineswhetheritfilesanenforcementactionagainstthecompany.Thedecisionwhethertobringacasecantakeatleastoneortwoyears.

AtissueatGlobalCrossingare20-yearcontractsfortelecommunicationscapacity,so-calledindefeasiblerightsofuse,orIRUs,whichcarriersfrequentlyswapwithoneanother.GlobalCrossingusedacommontechniqueofacceleratingrevenue,atechniqueallowscompaniestorecordrevenueinthecurrentquarter(acceleratingrevenue)whiledelayingrecognitionoftherelatedcosts(delayingexpenses)forseveralquartersoryears.Thiscanboostrevenuefortheearlyquarters,butifbusinessactivityslows,earningswilldropasrevenuegrowthfallsandexpensesremainunchanged.

SuchswapsareattractivetoGlobalCrossingastheysoldlong-termcontracts(sometimescalledindefeasiblerightsofuse)thatallowothertelecommunicationscompaniestousetheirfiberroutes,andbookedthelumpsumpaymentasrevenueinthequarteritreceivedthecashpayment,althoughtheservicewas,infact,supposedtobedeliveredoveraperiodofseveralyears.Globalalsoenteredintoseparatecontractswithanother(orthesame)telecomtobuycapacityontheirfiberandrecordedthesecostsasanassetthatwasexpensedoverthelifeofthecontract(alsoseveralyears)andwhichresultedinsmallquarterlyexpenses.Inessence,Globalwasaccountingforalltherevenuefromprovidingaserviceinasinglequarter,whileaccountingforthecostofprovidingthatserviceoverseveralyears."Everysingletransactionthatwedidwasauditedandproperlyrecorded,"saidGlobalCrossingChiefFinancialOfficerDanielCohrs.


Bausch&Lomb

InDecember1993,Bausch&LombInc.hastilysummonedits32independentcontactlensdistributorstoameetingatthecompany'sRochesterN.Y.headquarters.AsthedistributorsfiledintotheDec.13meeting,theyfiguredsomethingbigwasup.Theyweren'tdisappointed.HaroldO.Johnson,thelongtimeheadofB&L'Scontactlensunit,announcedachangeinsalesstrategy.B&Lwantedtocutitsdirectshipmentstoeyedoctorsandfunnelmorebusinessthroughthedistributors.Toensuretheycouldmeetrisingdemand,Johnsontolddistributorsthey'dhavetoboostinventories.Thencamethebombshell.B&L'Ssalesrepresentativesgaveeachdistributoralistoflensestobuy.Theamountswerestaggering:uptotwoyears'ofinventory.Moreover,priceswereatleast50%morethanB&LchargedjustthreemonthsearlierandthelenseshadtobeboughtbyDec.24,whenB&Lclosedits1993books.Johnsonsayshemadeitclearthatanyonerefusingtotaketheirquotawouldlosetheirdistributorship."WhenyourNo.1vendorsaysyou'dbettertakeitorelse,what'reyougoingtodo?"saysJamesButner,presidentofDoctor'sOpticalSupplyInc.inVinita,Okla.Intheend,allbuttwoagreed--andbyJanuary1994,B&Ldroppedthetwoholdouts.Hard-nosedtactics?Youbet.Thedistributorswallowedcloseto$25millionworthofgoodsinthewaningdaysof1993,boostingB&L'SU.S.contactlenssales20%,to$145million,andprovidingabouthalfthedivision's$15millioninearningsfortheyear.SoonthetransactionwouldcomebacktohauntB&L.InJune1994,itannouncedthat"highdistributorinventories"initscontactlensandsunglassbusinesseswouldseverelyhurt1994results.Third-quarterprofitsplunged86%,tojust$7.7million.B&L'sstockslid40%.Mostdistributorstellaremarkablysimilartale:Companyexecutivespromisedthatthedistributorswouldn'thavetopayforthelensesuntiltheyweresoldandsaidthatafinalpaymentwouldberenegotiatediftheprogramflopped."Paymenttermswerescheduled,butIhadverbalassurancesthattheywouldn'tforcethroughpayment.Ifsalesweren'tsufficient,theysaidtheywouldreevaluatewithaneyetowardextendingtheterms,"saysDavidRush,presidentofFirestoneOpticsInc.inKansasCity,Mo.Tenmonthsafterthesale,B&Lhadcollectedlessthan15%ofthemoney--andsomedistributorsneverpaidadimeforlensesworthhundredsofthousandsofdollars.Ifthedistributors'talesareaccurate,Bausch&Lombappearstohavestrectchedaccountingprinciplesforrevenuerecognition.Bausch&Lombexecutivesstronglydenychargesofaccountingirregularities.Theyportraythesaleasafailedmarketingprogram.TheyconcedethatdistributorsweretoldtheycouldpayonlyforwhattheysoldduringthefirstsixmonthsbutinsistthatfinalpaymentforthelenseswasdueinJune."Ithasalwaysbeenourpolicywithdistributorsthatwhattheybuy,theyown,"saysJohnson."Isaidtwothingsspecificallyatthat[December]meeting:Thepaymentmustbepaidwhenitcomesdue,and'youownthisinventory.'Idon'tknowhowanybodycouldmisreadthat."StephenMcCluski,B&L'scontroller,saysthecompany'sfinancialstaffanditsoutsideauditors,PriceWaterhouse,twicereviewedthecontactlenstransactions.'Ouraccountingtreatmentwasappropriate,"hesays.InOctober1994,B&Lagreedtotakebackroughlythree-quartersoftheDecemberinventoryanddiscounttherest,resultingina$20millionsalesreserveinthethirdquarter.The60-year-oldJohnsonsteppeddownfromhispostatmid-yearbutremainedonthepayrolluntilMarch1995,whenheretired.Through1993,B&Lposted12straightyearsofdoubledigitgrowthinearningsbeforenon-recurringcharges.Butgrowthhasbeentougherinrecentyears.Thecontactlensbusiness,whichaccountsfor17%ofsales,hasbeenhammered.B&Lstucktoolongwithtraditionallenses,whilethemarketshiftedtofrequentreplacement


modelsandtodisposablelensespioneeredbyJohnson&Johnson.In1992,J&JelbowedperennialleaderB&LintosecondplaceintheU.S.B&Ltriedtoperformatrickybalancingact:rampingupsalesofthenewerlenseswhilemaintainingastrongpieceoftheshrinkingbutfarmoreprofitablemarketfortraditionallenses.Butwithresourcesshort,B&Ldecidedtoletdistributorstakealargershareofthetraditionallensbusiness.B&LdescribedtheDecembersaleasagreatdealforthedistributors.Iftheyboughtmoretraditionallensinventory,B&Lwouldallowthemtoselltolargeaccounts.Johnsonsaysthedistributorsneededtheinventorytoservesuchaccounts.Moreover,theshiftwasaccompaniedbypromotionalprograms."Wesaidtoourdistributors,'Youbecomeouragent,"'saysJohnson."'We'llmoveourwarehouseintoyourwarehouse."'Distributors'reactions,Johnsonadds,were"excellent."Butifdistributorswelcomedtheidea,manysaytheywereveryunhappyabouttheinventory.Theysaytheyalreadyhad4to12months'worthofsuppliesafteranearlierpromotioninSeptember1993.TheyaddthatB&Lrefusedtoletthemsimplyordermoreinventoryasneededlateron--andtheywonderedwhytheordershadtobemadeinthe11daysbeforeB&L'sfiscalyearended."Itwasjustablatantattempttomaketheirnumbers,"saysMichaelElton,adistributorinDallas.Johnsondeniesthatthequicklyorganizedpromotionwastiedtotheyearend.Instead,hesaysB&Lbelievedthatdistributorswouldbemoremotivatedtosellitsproductsiftheyhadstockonhandthattheywerecommittedtopayingfor.Butdistributorssaytheyweren'tcommittedtopay.AftertheDec.13meeting,B&Laskedeachtosignapurchaseagreementandapromissorynote.Distributorswouldmakefivesmallmonthlypayments,withafinalballoonpaymentofaround60%dueinJune1994.B&Lchargednointerestontheinventoryinthemeantime.EvenB&L'sMcCluskisaysthefirstpaymentswerenotfirm."Forthefirstsixmonths,thepaymenttermswerebasedonthedistributors'sell-throughofthatinventory,"hesays,addingthatpayment"didn'thavetobeaspecificamountamonth."YetmanydistributorssayB&L'ssalesrepspromisedorallythattheballoonpaymentwouldbeextendediftheydidn'tsellthelenses.B&LsaysthatwhileJohnsontolddistributorshewould"reevaluatetheprogram"ifitdidn'twork,therewasnospecifictalkofextendingpayment.Buttwodistributorssaytheyprotectedthemselvesinwriting."Ihadanaddendumtothenote,sotospeak,thatwehadnoobligationtopay,"saysButner."Ifpushcametoshove,alltheycoulddowastotakeitback."RuschofFirestoneOpticsaddedaclausereservingtherighttoreturnthelensesforfullcreditinlieuofpayment.B&Lsaysitcan'tfindButner'snoteandsaysthattheadd-onclauseswerenotlegallybinding.Suchwrittenagreementsunderscorewhythisshouldn'tberecordedasrevenuesincetheyindicatedquestionsoverwhetherthedistributorshadassumedtherisksfortheinventory.Severaldistributorssimplyrefusedtosignthepromissorynote."Ineversignedanythingtopayinintervals,"saysEverettWest,vice-presidentinchargeofcontactlensesatOmegaGroupinDallas."Itoldthem,ifyouwanttoputinventoryinmyhouse,fine.Butweweren'tresponsibleforpaymentuntilwesoldit."Oncethelensesreachedthedistributors,themerchandisesataroundformonths,oftenunopened."Ihadboxespiledsevenfeethighinmyemployeebreakroomforayear,"saysButnerofDoctor'sOptical.Whiletheplantoshiftsalestodistributorsdidimprovebusinessformany,theup-tickwassmalloneproblem:B&Lcontinuedtoselllensesdirectlytohigh-volumeeyedoctorsandchains.AnexecutiveatonesmallopticalchainsaysitcouldbuyOptimaFWlensesdirectlyfor$9inearly1994,wellbelowthe$11.90B&Lchargeddistributorsforthesamelenses.ByJune1994,whenthefinalballoonpaymentfelldue,manydistributorssaytheyhadn'tsoldasinglelensfromtheDecemberinventory.McCluskiconcedesthatfewofthe30madetheballoonpayment.B&L'Saccountingstafftriedtocollectthemoneyduringthesummerbutmetfierceresistance."Itold'em,yourcompanyisabunchofliars,"claimsone."Theytolduswhentheyshippedit,itwasonapay-as-you-use-itbasis.Wedidn'tuseit,soweweren'tobligatedtopayforit."AlthoughB&Lstoppedshippingneworderstosomedistributors,itdidlittletoforcecollection.AfterJohnsonsteppeddownasheadofthecontactlensdivision,newheadCarlSassanoagreedtotakebackmostofthelenses.Somedistributorssentbacknearlytheentirepurchase.Othersshippedbackabouttwo-thirdsandweregiventwomonthstopayfortherestatabigdiscount.Themovehasquietedmuchdiscontent."They've


cleanedupourwarehouse,"saysMichaelAbbruzzese,presidentofTargetIndustriesinCohasset,Mass."They'vebeenfair.Theysawtheymadeamistakeandtriedtorectifyit."ButcleaninguptheinventoryproblemhasdonelittletoaddressB&L'Srealcompetitivetroubles.Moreover,B&L's1994proxylistsJohnsonasearninga64%performancerelatedbonusontopofhis$275,000salaryfor1993,thankstoperformance"substantiallyinexcess"ofcompanygoals.Thecompanyhasaltereditsexecutivecompensationsystemstoassurethatequalattentionisfocusedonthebalancesheetaswellastheincomestatement.

end

BusinessWeekDecember19,1994


MediaVision

JamesChanoshadtaggedMediaVisionasaloserinlate1992.ChanoshadfiguredMediaVisionwasinalousybusiness:circuitboardsforcomputerswerehotbusinessbuteventuallywouldfizzle.InJuly1993,JeffMatthews,ananalystatRockerPartners,sawabuildupinMediaVisioninventories.MatthewsbecameconvincedthatMediaVisionwasheadedforafall,sohewalkedintotheofficeofhisboss,DavidRocker,tomakeacase.MatthewsisanumbercruncherbutasalwayshisargumentwentbeyondmathandappealedtoRocker'sgutinstinct."Nowisthetime,"theanalystsaid.Rockeragreed,andthebetwasplaced--abetthatultimatelywouldgrowtoabout$10million.Beforelong,othershort-sellershadreachedthesameconclusionsasChanosandRocker.Theywerechallengingtheconventionalwisdom.AllanalystswererootingforMediaVision,acompanywithsoaringsalesandasoaringstockprice.Thebattlewason.Short-sellersaren'tnihilists.They'recontrarians,sure.Bynature,theytaketheminorityview.Whatreallywinsthemenemies,however,isthatthey'renotcontentjusttoavoidbadstocks.Instead,theyfeelcompelledtobetagainstsuchstocks,thendoeverythingintheirpowertomakethebetstick.Inthegameofinvesting,whereeveryoneelsewantsstockstorise,short-sellingisseenasbadkarma.Intheory,ofcourse,short-sellerscan'taffectacompany'sfortunesjustbymakingabet.Inreality,though,theycanmakeotherinvestorssoskittishthatanybadnewswillcauseafloodofsellordersfrombullswhosuddenlyfeartheshortsmayberight.Suchsellingspreesdepressastock'spriceandmaketheshorts'betaself-fulfillingprophecy.Short-sellershavealso,onoccasion,beenaccusedofquestionablemovessuchasspreadingfalserumorsorbad-mouthingacompanytoitssuppliersorcreditors.Respectableshorts,likeMatthewsandRocker,saytheyneverdosuchthings.Inotherways,however,thesemenaregreatexamplesofthearchetypalshort--tireless,fanatic,detail-orientedinvestigators.Shortsarelikepitbulls.Oncethey'velatchedontoatarget,theywon'tletgountilthestockcollapsesorthey'velostafortune.Convincedtheirstandiscorrect,they'llmagnifyeventhetiniestflawsinacompanytoproveapoint.Unlikemanyinvestors,shortsdotheirhomeworkextremelywell.Andasaresult,theyareoftendead-onintheirjudgments.ThatwasthecasewithRockerPartnersandMediaVision.Ofcourse,investorsinthecompanyaren'tthankingRockerformakingmoneyofftheirmisery.Andaswithmanyshortvictories,thestoryofhowRockerwasprovedrightisnotpretty.


ARRAYEDAGAINSTROCKERANDtherestoftheshortsintheMediaVisionfightwerethevastmajorityofmoretypical"long"investors,whoboughtthestockhopingitwouldriseinprice.Suchlong\shortbattlesgoonallthetime,althoughsmallinvestorsmaynotrealizetheirstockhasbeentargetedbyshort-sellersuntilitcollapses--orbeatsofftheattackinwhat'sknownasashortsqueeze.Short-sellerskeepalowprofile,buttheyoftenworkfeverishlybehindthescenestoconvincebankers,analysts,biginstitutions,andjournaliststhataparticularcompanyisabouttohittheskids.Astheshortsbuildadoomsdaycase,aimingtotouchoffastockslidethecompanyanditssupportersmarshalevidencetoprovethatalliswell.Disagreementsbetweenlongsandshortsareusuallyprettymundane--whetheranindustry'sfundamentalsaredeteriorating,forexample--buthavebeenknowntoescalatetochargesofmisrepresentation,evenfraud.WhenitcametoMediaVision,theshortsfacedsomeseriousfirepower.Foronething,MediaVision'spublicofferinghadbeenco-underwrittenbyMontgomerySecurities,abrashWestCoastinvestmentfirmwithplentyofpowerfulallies,andCowen&Coo.,aNewYorkfirmwithaspecialtyintechnologyissues.MontgomeryandCowencouldbeexpectedtofighthardtoavoidtheembarrassmentofseeingaclientgetslaughteredinthemarketplace.Ifsuchahumiliationoccurred,thefirms'reputationforsponsoringqualitystockswouldbetarnished.Thatcouldscareawayfutureclientsandthefeesandcommissionstheywouldbring.AnothersnagforRockeranditsfellowshorts:MediaVision'sbiggestinstitutionalshareholderwasthemutualfundgiantFidelityInvestments,whichatonepointheldabout12percentofthecompany'spubliclytradedsharesthrougheightdifferentfunds.Fidelityisahugeforceinstockbuying,anditsconfidenceinanissuedoesmuchtoreassureinvestorswhomightotherwisebespookedbyshorts.AddtothisthesecuritiesanalystswhowererecommendingthattheirclientspurchaseMediaVisionshares,andthebattlelinesweredrawn.Ahighflierinthehotcomputerfieldknownasmultimedia,MediaVisionwasperfectfodderforashowdownbetweenshortsandlongs--amuch-hypedplayerinaturbulentindustry.Thecompanyhadbeenfoundedin1990byPaulJain,animmigrantborninNewDelhi.Jain(pronounced"Jan")wasahigh-techveteranwhotracedhisinterestinmultimedia,whichspicesupcomputingwithaudioandvideoelements,toaboyhoodfascinationwiththebustleandcolorofIndianopenairbazaars.Smooth,welldressedandcharming,Jainwasacolorfulfigurehimself.Ashetoldit,hehadgrownupinawealthyIndianfamilywithdividedpoliticalloyalties.Hisfatherranastringofsteelplantshandeddownfromthedaysthefamilyobeyedcolonialrule.Fromhismother'sside,meanwhile,cameaninsurgentstreak:Hismaternalgrandfather,asupporterofMohandasGandhi,hadbeenjailedforprotestingtheBritishpresenceinIndia.In1962,attheageof17,JainleftIndiaforAustria.Heremainedthereforadecade,earninganengineeringdegreefromtheUniversityofViennaalongtheway.ButeventuallyhegottiredofAustrianhostilitytowardforeignersandheadedforafriendlierclimate:California.JainenrolledinagraduateprogramattheUniversityofCaliforniaatBerkeley,wherehereceivedamaster'sdegreeinbioelectronics.FromBerkeleyJaingravitatedtowardnearbySiliconValley,whereheworkedandinvestedinaseriesoftechnologycompanies.Healsofoundedtwoofhisowncompanies--UniversalSupply,whichsoldcomponentstobigcomputermakers,andVideo7,whichmadecomputer-graphicscircuitboards.MediaVisionwashisthirdcreationandappearedsuccessfulfromitsearliestdays:In1992,itssecondfullyearinbusiness,MediaVisionhadrevenueof$69million,mostlyfromsellingsoundcardsthatenabledcomputerstoproducegood-qualityaudio.Indeed,Jainhadpickedanindustrywhereitwashardnottodowell.Drivenbyeverimprovingcomputergames,multimediaadd-insforcomputerswereonamonumentalrollintheearly1990s."Nomatterwhatyoumade,youwouldhavesolditall,"recallsChipLacy,chiefexecutiveofficerofIngramMicro,aleadingdistributorofcomputers,software,andaccessories.MediaVision'schiefrival,fromwhichithadlicensedsomekeytechnology,wasCreativeTechnology,patentholderfortheproductthathadlaunchedthesound-cardboom--apopularcircuitboardknownasSoundBlaster.MediaVisionandCreativeTechnologyviedtooutdoeachotherinthefast-changingfield,racingtowringoutbigger,better,andfasterproducts.Tohookconsumerson


multimedia,theybeganbundlingsoundcardsinto$600"multimediaupgradekits"thatincludedspeakers,adevicethatplayedspecialcomputercompactdiscs,andanarrayoffancysoftware.Salessoared.Withasuperhotindustryandastockmarketthatwassnappingupinitialpublicofferings,itwasn'tlongbeforetherivalsound-cardcompaniescaughttheeyeofinvestmentbankers.GoldmanSachssnaredCreativeTechnology,takingitpublicinAugust1992.ItwasaninstanthitandsetthestagenicelyforJain'scompany.MediaVisionmadeitsstockmarketdebutonlythreemonthslater,courtesyofMontgomeryandCowen.Itraisedanimpressive$52million-thenreturnedtothecapitalmarketsjustfivemonthslater,boastingofunusuallystrongsalesgrowth.Thistimeitraisedanother$52millionfrominstitutionalinvestors.TheofferingshelpedmakeJainarichman:Aspartofthedeals,hesoldsharesworthmorethan$1.5million.Entering1993,MediaVisionwasalmostthedefinitionofaWallStreetdarling.Inthefirstmonthoftheyearalone,itsstockrosealmost44percent.Bythecontrarianstandardsofshort-sellers,thatalonemightserveasawarningflag:There'sathinlinebetweenahotstockandanoverheatedone.AtRockerPartners,however,JeffMatthewswouldfindevenmoretoworryabout.SHORT-SELLERSaren'tLIKEOTHERinvestors.Foronething,theytendtobelieveinfundamentalresearchoncompaniesandindustries--andnothingelse.Thatmeanstheydon'tcarewhattheanalystsaresayingorthecompanyitselfisforecasting.Iftheirresearchshowsthatacompany'sstockpriceisn'tmeritedbythecompany'sfundamentals,they'reinterestedinbettingagainstit.Duediligenceiseverything.Matthews,hadgainedhisreputationasaformidableshort-sideanalystin1987bycallingthefallofRegina,avacuum-cleanercompanythateventuallyfiledforbankruptcyprotection.Atthatpoint,Matthewswasshortingforhisownaccountonly,ashehadsince1983.Forhisfull-timejobasaninvestmentanalyst,meanwhile,herecommendedbuysonotherstocksforemployerWarburgPincus.ButasMatthewsbecametheWallStreetexpertonRegina,theyoungLehighUniversitygraduatemadesomeimportantcontacts.AtaconferenceattheIntercontinentalHotelinNewYork,hedeliberatelysatnexttoDavidRocker,awell-establishedmoneymanager,andtalkeduphisReginafindings.By1989,RockerhadenticedMatthewstojoinhisfirm.Unlikemanyofhisbrethren,includingJamesChanos,DavidRockerisn'tpurelyashort-seller--Indeed,he'sjustasproudofhissmartlongs,suchasCanandaiguaWine,asheisofhisspectacularshorts,suchasTCBYandU.S.Surgical.BorninElizabeth,NewJersey,Rockerisa51-year-oldnavyveterananddoubleHarvardgrad(collegeandbusinessschool)who'sactiveincharitableorganizations.Hisbiggestcharge,however,comesfromdeflatingfalseclaims.Andforthepast25years,thathasmadehimashortatheart."Dispassionateresearchagainsthype"ishowthewell-groomed,intenseRockerframeshiscalling.AndinthecaseofMediaVision,that'sexactlywhathesawfromJeffMatthews.InJuly1993,forexample,MediaVisionhadissuedapressreleaseclaimingithadan85percentshareofthemarketforaparticulartypeofsoundcard.ButMatthewsfiguredthatthetrueMediaVisionsharewasmorelike30percent."Thatwasatip-off,"saysRocker."Whenyouseethat,youstartlookingforotherthingsthatdon'taddup."Preparingfortheshortbet,RockerandMatthewscheckedoutMediaVisionasmanydifferentwaysastheycould.AlongwithpartnerMarcCohodes,whoisbasedinLarkspur,California,theyworkedthephonesfuriously,callingcomputer-storecompaniesandcompetitivemanufacturers.Asresearchprogressed,RockerwasconvincedthatMatthews'sinitialinsighthadbeencorrect:Thishadallthesignsofamajorshort-sellingopportunity.Besidesitsinventoryproblems,MediaVisionwasbleedingcashandwastrappedinanindustrythatwouldn'tbeabletosustainitshighmargins.Matthewsbelievedthatcompetitionwouldsoontransformsoundcardsintojustanotherfactory-installedcommodity,muchasdiskdriveshadturnedintoacutthroatbusiness.ButPaulJainwasmakingrosyassumptionsthatprojectedhighprofitsforyearstocome--andthestockmarket,ledbybreathlessrecommendationsfromMontgomery,Cowen,andcreduloussecuritiesanalysts,seemedtobe


valuingMediaVisiononthatbasis.SuchmisplacedoptimismisjustwhatRockerlooksfor:Realityusuallyintervenessendinganovervaluedstockcrashingdown.Rockerdescribestheclassicshortas"awidediscrepancybetweenthefactsandwhatacompanyclaims,andarefusalofabroadnumberofanalyststodealwiththat."HebelievedhehadfounditinMediaVision.Thatmonth,RockerstartedplacingbigbetsbyborrowingMediaVisionsharesandsellingthem.Hewasgamblingthatthepricewouldfall,allowinghimtoreplacetheborrowedstockwithcheapershares.Aswithanyshortbet,thepotentiallosswasenormous--theoreticallylimitless,infact.AsMediaVision'sstockroseabovethelevelatwhichRockerhadsoldit,hispositionwasinthered.IfJainandthelongswereright,andthestockkeptrising,Rockerwouldjustkeepgettingindeeperanddeeper.Insuchasituation,Rocker'sonlydecisionwouldbehowmuchmoneyhisfirmcouldlosebeforebailingout.Still,Rockerhadthecourageofhisconvictions.RockerPartnersmanagesabout$200millionforwealthyindividualsandinstitutions.Likeanymoneymanager,Rockerisn'tsupposedtorisktoomuchofhisclients'moneyonanysingleinvestment.Ultimately,though,theMediaVisionshortwouldbecomeoneofRocker'sbiggestpositions,accountingforabout5percentofhisfirm'sinvestments.Takingahitonabetthatsizewouldn'tjusthurthisperformance--itcouldcosthimclients.MEANWHILE,MEDIAVISIONseemedunstoppable.InSeptember1993,PaulJainwasaskedtostepbeforeapackedgatheringofthecountry'smostpowerfulmoneymanagers.Themarketwasexpectinggoodnews:MediaVision'sstockjumped10percentintheweekbeforehisappearance.AndJaindelivered.HismessagewasjustwhatRockerdidn'twanttohear.ForMediaVision,saidJain,thebestwasyettocome.JainwasaddressingtheannualMontgomerySecuritiesinvestmentconferenceinSanFrancisco,thelargesteventofitskind.HeretopexecutivesparadebeforetheWallStreetcommunity,tryingtopersuadehugepensionfunds,mutualfunds,andotherinstitutionstobuyintotheircompanies.IfJain'spitchwentwell,hecouldexpectafloodofmoneythatwouldfundanupcomingbondofferingandhelpdriveMediaVision'sshareshigher.Thatwouldn'tjustaidthecompany;itwouldmakeJainevenricher.EverypointthatMediaVisionstockroseaddedabout$134,000tohisnetworth.TheSeptember1993bash--Montgomery's23rd--wasbiggerandflashierthanever,afull-throatedtoasttoabullmarketthathadheapedrichesontheSanFrancisco-basedfirm.Attendeessipped$30-a-bottleChardonnayandweretreatedtoanentertainmentlineupthatincludedadebatebetweenjournalistsRobertNovakandMichaelKinsleyandtunesfromcountrysingerWaylonJenningsandpopartistBruceHornsby.Buttherewasalsoplentyofbusinesstobedone,andoverfourdaysexecstooktheirturnsatthepodium.Jainmatchedthebestofthemwithhiscompellinggrowth-stockstory.Notonlywashisfledgingcompanysolidlyintheblack,hesaid,butanalystswereexpectingannualsalestotriplein1993,toarobust$200million.Andthatwasonlythebeginning.Jainhaddreamsofbuildingamulti-mediacolossuswith$1billioninsalesandamarketvaluetomatch.HecaptivatedtheaudiencewithstoriesofMediaVisionexpandingbeyondsoundcardsandmultimediaupgradesintohigh-marginsoftware--specifically,thesametypeofcompactdiscgamesthatweredrivingdemandforMediaVision'shardware.ItwasalreadySeptember,butJainpromisedthatMediaVisionwoulddroptentitlesdownretailers'chimney'sintimefortheChristmasrush."Youcouldseepeople'semotionswantingtobeinonthis,"remembersCohodes.Andsureenough,withinamonthMediaVisionstockhadrisenanother44percent.Theshortsweretakingadrubbing,buttheyremainedunbowed:ShortinterestinMediaVision,ameasureofhowmanybetshadbeenplacedagainstthestock,hadrisento14.1percentofthecompany'soutstandingshares,upfrom8.7percentonlythreemonthsearlier.BolsteredbytheenthusiasmoftheMontgomeryconference,Jaindismissedasnonsensethebalance-sheetconcernsraisedbyshort-sellers.Highinventoriesandunpaidbillswereone-timeproblemsthatwerealreadybeingfixed,heinsisted.Ontheinventoryside,JainsimplyclaimedMediaVisionhadturnedthingsaroundandwas"soldout"forChristmas.


Thehigherreceivables,heclaimed,werejusttheresultofgrantinggenerouscredittermstobigretailerssuchasWal-Mart,whichhadneverbeforecarriedsoundcards."Itwasanewcategory,andtheydidn'tknowwhethertheycouldsellit,"Jainsaid.AnyoneshortingMediaVisionwouldbesorelydisappointed,hetoldareporter.Jain'sconfidenceseemedwellplaced.Investorscontinuedtocravemultimedia,andaconvertibledebtofferingbyMediaVision,underwrittenbyMontgomeryandCowen,wentoffwithoutahitchinOctober1993.Demandforthebondswassohigh,infact,thatthevalueofthedealwasultimatelyraisedfrom$75millionto$115million.Theverydayoftheoffering,MontgomeryanalystPaulFoxaddedtotheexcitementlevelbyhikinghisestimateofMediaVision's1994revenueby26percent.Thestockcouldjumpfrom$27to$40ashare,hesaid,describingMediaVisionas"oneofthebestpure-playcurrentinvestmentideasinmultimedia."Cowenwasequallyenthusiastic;itsanalystStevenOssadmadeMediaVisionhisnumber-onetechnologypick."Significantupsidepotentialloomsasweenter1994,"hewrote.Facingmillionsofdollarsinpotentiallosses,theshortswereunderhugepressure.INSIDEthecompany,PRESSUREWASbuildingtoo.Therewaspressuretokeepthestocksoaring,pressuretomeetWallStreet'soptimisticestimates,pressuretofulfillJain'sambitiouspromises.WhatmuchofWallStreetdidn'tknow-anddidn'twanttoknowwasthatJaindidn'talwaysreactwelltopressure.AmidalltheenthusiasmoverMediaVision,fewinvestorshadbotheredtocheckoutPaulJain'strackrecord.Iftheyhaddoneso,theywouldhavediscoveredapatternofquestionablepracticesthatshouldhaveraisedredflags.Forexample,UniversalSupply,thefirstcompanyJainfounded,filedforbankruptcyandwasliquidatedin1984amidcreditorcomplaintsoflaxmanagement.ThencameVideo7,themakerofcomputer-graphicsboards.Jainseemedtohavescoredasuccesstherein1989whenhesoldthecompanytoLSILogic,alargeandreputablecomputer-chipmanufacturer.Thatwasn'ttheendofthetale,however.LSIwon'tcommentonthemattersbutahigh-rankingexecutivewhoworkedforLSIatthetimesaysthecompanyfeltmisledbyJainwhenitdiscovered"tensofmillionsofdollars"inunsoldVideo7productsthatLSIhadneverbeentoldabout.Infact,saythisexecutive,LSIwas"appalled"athowJaindidbusinessandquicklyfireditsnewemployeeaftertheacquisition.TheexecutiveconcedesthatLSImayhavebeennaive,butthecompanywasshockedbyJain'sembraceofanaggressivepracticeknownas"channelstuffing"--offeringwhateverisnecessaryfordistributorstoacceptlargeshipmentsattheendofaquarter,justsothatsalesnumberswillhittheirtargets.Stuffingoftenbackfireswhenunsoldgoodsarereturned.Atitsworstitcanleadtokickbacks,althoughnosuchaccusationhasbeenmadeagainstJain.Throughhisattorney,JaindeclinestocommentoneventsatVideo7orUniversalSupply.MoretroublinginformationaboutJaincouldhavebeenuncoveredincourtrecords.Duringdivorceproceedings,forexample,histhenwifeKathleenallegedthatJainhadhiddenmoneyinoverseasbankaccountsmanagedbyrelatives.CourtdocumentsalsoindicatedthathehadgivenablockofVideo7stocktoawomanwithwhomhewashavinganextramaritalaffair.Thewomanlatersolditfor$47,000,accordingtocourtrecords.JainandhiswifealsohadtroubleswiththeInternalRevenueService--legalpaperstalkofa"filingproblem."NeitherJainnorhisex-wifewillcommentonthenatureoroutcomeofthesetaxdisputes.Evendiligentshort-sellersdidn'tknowmanyofthesefacts.Butotherdangersignswereinplainerview.Insidersweresellingthestockheavily,forinstance.AndatRocker,MatthewswasbecomingintriguedbyanewMediaVisionsalestactic,atoll-freetelephonenumberforsellingproductsdirectlytoConsumers.MediaVisionclaimeditsdirect-salespushwastoselloutdatedsoundcardsthatcouldn'tbesoldatoriginalretailprices.ButMatthewsdiscoveredthatMediaVisionwasalsosellingsomecurrentsoftwareprogramsoverthephone--atadiscount.Whydosuchathingiftheproductsweresellingsowellinthestores?AsChristmasapproached,MatthewstooktowanderingfromhisofficeinRockefellerCenter"toseewhatwasgoingon"atnearbycomputerstores.Hisconclusion:MediaVisionproductsweren'tselling--andJain'spromisedsoftwaretitleswerenowhereinsight.OnceagainRocker,Matthews,andCohodesbeganworkingthephones.Theircontactsatcomputerstorestoldthemthesamething."ThepurchasingguyatonechaintoldusthattheMediaVisionsalesmendidn'teventrytoselltothem,"Rockersays.Wordbegantospread,andshortinterestin


MediaVisionkeptrisingtoreach17.7percentofoutstandingsharesbymid-December.JainbeganbombardinganalystswithwildprojectionsforMediaVision'snewlineofsoftware,whichhestillsworewouldreachstoresbyChristmas.OfthetitlesJainpromised,thebestappearedtobeacompact-discgamecalledCriticalPath,whichcombinedtraditionalvideo-gamegraphicswithactualmoviefootage.InearlyDecember,Jainsaidthegamewouldbeafailureifitdidn'tsell100,000unitsbytheendofMarch"I'dbesurprisedifitdoesn'tsell200,000titles,"headded.Thehottestsuchgameatthetime,7thGuest,hadsold200,000copiesineightmonths;unsurprisingly,CriticalPathsaleswouldneverapproachthatfigure,letaloneJain'shyperbolicthree-monthestimates.ButJaincouldn'tbestoppedbysuchtechnicalities--hefollowedupbysayingMediaVisionwouldsoonstartbuildingleading-edgegamemachinesofthetypethenbeingtoutedbyahotcompanycalled3DO.HisdazzlingprojectionshelpedMediaVisionstockreach$40ashare.TheshortswereabsolutelyconvincedthestockwasbeinghelduponlybyhotairfromJainandWallStreetanalysts.Butsuchconvictionswerehurtingnoonebuttheshortsthemselves.Atthisstage,Rocker'sMediaVisionpositionwasintheredbymillionsofdollars."Weweregettingkilled,"headmits.Still,heheldtohisbeliefthatJain'spublicoptimismdidn'treflectthetrueMediaVisionstory.JainwasunimpressedwithRockerandhisgalleryofskeptics."Ihope[theshorts]rotinhell,"hetoldareporteratthetime."Ihopetheygohomeandbeattheirwives."SaysRocker,"Peoplewhohavesomethingtohidedon'tlikedetectives."MEDIAVISIONKEPTJAIN'spromiseaboutsoftware-butonlyjust.Nineofitscompact-disctitlesarrivedinstoresbyChristmasweek.Caughtbythedelay,Jainchangedhisstoryslightly.WhileacknowledgingthatChristmaswasimportant,henowsaidthe"realmoney"wouldbemadeafterChristmas,whenownersofnewmultimediasystemswentshoppingforsoftware.Investorsboughthisreasoning:Asthewinterworeon,MediaVision'sstockmarchedevenhigher,peakingat$46.50.Noweveryone,longandshortalike,waswaitingforMediaVision'slatestresultstocomein.


OnFebruary18,MediaVisionreportedthatitsfourth-quartersaleshadalmosttripledfromthepreviousyear.Butitsper-shareearningscameinslightlybelowseveralanalysts'estimates--andinthevolatile,high-expectationsworldofhottechnologystocks,thatwasalmostasbadasanunexpectedloss.What'smore,MediaVision'sinventoriesandreceivableshadshotupagain,suggestingthatmaybetheshortswereontosomething.Withintwodays,thestockshedroughly18percentofitsvalue,endingat$35ashare.Clearlyagitated,Jainblamedtheslideon"manipulation"bytheshorts.Infact,heargued,thestockhadbeenundervaluedbeforeittumbled.TheinventorybuildupwastheresultofstockpilingmaterialsforahotnewmultimediakitthatMediaVisionwouldsoonintroduce,Jainsaid,whilereceivableswerehighbecausesomeretailerswerehavingtroublemovingolderMediaVisionproducts.Again,theglitchesweretemporary."Theshortshavetounderstandthatthey'llbeburnedbyme!"Jainrailed.Andindeed,mostofthesecuritiesanalystswhofollowedMediaVisionreiteratedtheirbuyrecommendationsaftertheslide,downplayingthecompany'sbalance-sheetwoes.MediaVision'spatronatMontgomerySecuritiessetthetone:AnalystPaulFoxcalledthefigures"disappointingbutexplainable."Thiswasn'tjustaregurgitationofJain'spartyline--FoxsayshedidindependentresearchtoreassurehimselfMediaVisionwassolid."Allmycontactsacrosstheboardweresayingthingswereamazinglystrong,"hesays.Allthesame,severalbrokeragehousesloweredtheirearningsestimatesforMediaVision,andthestockcontinuedtolanguish,hitting$21.50bylateMarch.FormuchofWallStreet,however,thatjustmadeMediaVisionlookevenmorelikeabargain.Buy,urgedtheanalysts.Theshortsweren'tbuyingyet,however.Theyhadseenasignthatfurthercollapsewasimminent.AsJainkepttoutingMediaVision'sstrength,thecompanyhadquietlytakenoutaclassifiedadinElectronicBuyersNews,atradepaper."SiliconValley-basedcompanyhasthefollowinglistofexcesscomponentinventoryforsale,"itread.Theaddidn'tidentifythecompany,butshort-sellersarecannyaboutsuchthings.Matthewscalledthenumberlistedinthead.HegotMediaVision.Bythispoint,MatthewshadleftRockertostrikeoutonhisownasamoneymanagerinGreenwich,Connecticut.Hehaddeparted,ironically,ontheverydayinFebruarythatMediaVisionbegantodisappointWallStreet.Still,theloyalMatthewscalledhisoldbosstopassalongtheinformation.ThelistofitemsMediaVisionwasofferingforsaleincludedmillionsofcomponentsusedforbuildingsoundcards.Sellingsuchstuffviaaclassifiedadisunusualintheelectronicsindustry.RockerandMatthewsfiguredMediaVisionwastakingdesperatemeasurestodisguiseyetanotherinventorybuildup--thistime,beforeitshowedupinanearningsreport.Wasthecompanyinevenworseshapethantheyimagined?Theanswercamesoonenough.OnthenightofWednesday,March23,1994,thethreeoutsidedirectorsofMediaVisionweresummonedtoanemergencyboardmeetingintheconferenceroomatMediaVisionheadquartersinFremont,California.Theretheyweretoldthatthecompanywouldreporta"significant"first-quarterloss.Jainblamedthetroubleonpricecutsandshipmentdelays.Newsofthelosshitthetapethefollowingmorning,slicingMediaVision'salready-batteredstockalmostinhalf,to$11.50ashare.Jainputonabraveface,dismissingtherevelationaslittlemorethanabumpintheroad.Inahastilyorganizedconferencecallwithanalysts,thesomber-soundingexecutivetriedtoavoidrealitybytalkingaboutthecompany'snewlineofchildren'ssoftware.Thestockdriftedlower.Onlysixweekslater,anotherbombshell.Thecompanysaiditwouldberestatingitsfourth-quarterresults.Insteadofaprofit,MediaVisionnowexpectedasignificantloss.ThenextdayMediaVision'sstockclosedbelow$6.Thebattlewaseffectivelyover;theshort-sellershadwon.Asthecynicspoppedchampagnecorks,longinvestorsstartedtotinguptheirlosses.Whathappened?MediaVisionhasyettogiveanadequateexplanation--andJaininsiststhecompanymostlyfellafoulof"untruthfulandunfairallegations."ButaccordingtointernaldocumentsandinterviewswithformerMediaVisionexecutivesandemployees,thetruthofthesituationismuchlessflattering.DESPITEJAIN'SCONSTANTassurancestothecontrary,theshort-sellersappeartohavebeenrightaboutMediaVision.Inalong,damningstorypublishedintheSanFranciscoChronicle,numerousformeremployeespaintedapictureofacompanysoobsessedwithmeetingJain'swildforecasts--andWallStreet'soverheatedestimates--thatithadslippedintosomedubioushabits.MediaVisionregularlyshippeddefectiveproducts,thesepeople


say.Attheendofmostquarters,white-collaremployeeswouldpitchintopackasmanyboxesaspossible.Jainprowledthefloor,providingmotivationandorders.Peoplewhoweretheresaythatanyonewhopointedoutadefectgotthesameresponse:"Shipit!"Saysoneformeremployee,"Analystsexpectedhimtohithisnumbers,andhehitthem.Nomatterwhat."Jainalsoappearstohaveoverseenthesamekindof''stuffing''practicesatMediaVisionthatapparentlypromptedhisdeparturefromVideo7.Accordingtodistributorsandretailers,MediaVisionfrequentlyaskedthemtotakemoresoundcardsandmultimediaupgradekitsthantheycouldpossiblysell.Ononeoccasionlatein1993,saysadistributor,"theyaskedustobuymorethanweevertookinanentireyear".Evenmoretroublingisevidencethatthecompanyknowinglyfalsifiedsalesfiguresbyclaimingtohaveshippedthousandsofproductsthatweren'tevenmadeyet.Latein1993,asJainwasmakingpromisesaboutfuturesales,MediaVisionfounditselfshort15,000speakersitneededtocompletesomemultimediaupgradekits.OnDecember2,1993thecompanyorderedthespeakersfromLabtecElectronicsinHongKong,tobeshippedonthefreighterEverGarland.OnDecember30,thecompany'sinternalinventorylogshowedthespeakers"received,"andaworkorderwasissuedtoanoutsidecontractorforcompletionoftheupgradekits.Accordingtoapackingslip,10,000ofthekitswereshippedbacktoMediaVisiontheverysameday.Thefollowingday,accordingtoinventorylogs,thesekitswereacceptedintoMediaVision'sinventoryandquicklyreleasedtosalespeople.Thesalespeoplethenassignedthekits,valuedatmorethan$3million,tovariouscustomers.Oncethathappened,accordingtoformeremployees,theproductsweresaidtobeshipped--justintimetoberecordedassalesforthefourthquarter.Theonlyproblem:TheEverGarlanddidn'tevenarriveintheU.S.untilJanuary8--morethanaweekafterthespeakersitcarriedweresupposedlyusedinMediaVisionkits.Thesaleswereafabrication.There'salsoasuggestionthatMediaVisionrented"phantom"warehousestohidestuffedinventorythathadbeenreturnedunsold--andwouldotherwisehavetobedeductedfromsales.SandyPfister,aformersecretary,saysJainfalsifiedsalesfiguresbyclaimingtohaveshippedproductsthatweren'tevenmadeyet.Atonetime,Pfistersays,shereceivedbillsforwarehouserentalsaboutwhichsheknewnothing.WhensheconfrontedaJaindeputywithsuspicionsaboutwhatwasinthewarehouses,shesaysshewastold,"It'snoneofyourbusiness"'Pfister,whohassinceleftMediaVision,alsoaccusesJainoftryingtousecompanyfundstobuyairlineticketssohecouldtraveltoParisandelsewherewithgirlfriends.WhileshewasJain'ssecretary,Pfistersays,sherefusedtoprocesssuchexpenses--butJain"wouldgobunkers...Hewouldredotheexpensesandgivethemtothecontrollers."Throughhisattorney,JaindeclinestocommentonthisallegationandallothercharacterizationsofhisroleatMediaVision.EvenbeforeMediaVision'scollapse,someformerexecutivesandemployeesweresodisgustedwithcompanypracticesthattheycomplainedtoareporter--andlatercontactedtheSecuritiesandExchangeCommission.AlongwiththeFBI,theSECisnowinvestigatingthecompany.Asthesedevelopmentswerereported,theshorts'victorybecameevermorecomplete.MediaVision'sstocksankaslowas$2.63ashare.Itsbondsfellbelow20centsonthedollar.Halfthecompany'sboardquitwithinthreedaysoftheChronicleexpose.Aweeklater,Jainandthreeofhislieutenantsresigned.WhenMatthewsheardthatnews,hesentelectronicmailcongratulatinghisoldfriendsatRocker.RockerandCohodes,meanwhile,werebothjubilantandrelievedaftersurvivingmonthswhenitseemedtheymightlosemillionsontheMediaVisionbet."Wefeltreallygood,"saysRocker."Itwasaverybigwin."ALTHOUGHhisfirmWASprovedright,alongwithalltheotherMediaVisionshort-sellers,Rockerwasn'thailedasaherowithintheinvestmentcommunity.He'susedtothat.Short-sellersareridiculedwhenthey'rewrong,reviledwhenthey'reright.Theymaymakemoney,buttheyseldommakeanyfriends.Exceptamongtheirclients,thatis:WithoneofthelargestshortbetsonMediaVision,theRockerfirmendedupclearingmorethan$5millionforitsinvestors--mostlytakenfromthehidesofpeoplewhochoseinsteadtobelievePaulJain,MontgomerySecurities,Cowen&Co.,andthesecuritiesanalystsatanumberofbigbrokeragehouses.


MediaVisionbecameatroubledcompanydealingwiththefalloutfromongoinginvestigations.InJuly1994,itwasforcedtoseekfederalbankruptcyprotection.Inalettertofriendsthedayheresigned,Jainwhinedabouthistreatmentinthewholeaffair."Ithasalwaysbeenamysterytome,"hewrote,"howmencanfeelthemselveshonoredbythehumiliationofothers."PaulJainwillbedealingwithhishumiliationforsometime.Rocker,Chanos,andalltheothershorts,bycontrast,havealreadymovedon.Theirnexttargets?Rockerisn'tsaying.NeitherisChanos,whowasthefirstanalysttopickMediaVisionasaloser.NeitherisMatthews.ButifyouownahotstocklikeMediaVision,theyallsay,maybeyoushoulddoabitmoreresearch.Whilethere'sstilltime.

end


Lernout&Hauspie

SecuritiesandExchangeCommissionsleuthsbeganinvestigatingastartlingsurgeinsalesatBelgiansoftwaremakerLernout&HauspieSpeechProductsNV.TheyfoundakeystoponthemoneytrailwasNo.5ShentonWayindowntownSingapore.TheSECprobeapparentlyfocusedontheoncehighflyingcompany'srecentdramaticsalesincreasesinAsiaanditsdealingswithcorporatecustomerstowhichithasfinancialties.Themodernhigh-riseatNo.5ShentonWayistheofficialaddressof15firmsthattogetherpaidL&H$57million,nearly17%ofitsworld-widerevenue.L&Hsaysthesecustomersboughtlicensingrightstoitsspeech-recognitionsoftware.ButattheShentonWaybuilding,thereisn'tanyevidenceofoperationsofthe15L&Hcustomers.Theiraddressleadstoalawoffice,whereTanLeeChinemergestomeetavisitor.Ms.Chin,whoislistedinSingaporegovernmentrecordsasanofficerofanumberoftheL&Hcustomers,confirmsthatmanyofthecompaniesareindeedregisteredatthataddressbutdeclinestosaymore.Acrosstown,inascruffysectionnearSingapore'sred-lightdistrict,isthecommonaddressoffourmorecustomersidentifiedbyL&H.Thisoffice,abovealampshop,housesanotarypublic.Thereisalistofabout30companiesoutsidethedoor.NotoneisacustomernamedbyL&H.InterviewswithL&HofficialsandareviewofregulatoryfilingsanddocumentsprovidedbythecompanyrevealthatnearlyallofL&H'srevenueintheAsiancity-statehavecomefromthe19companies.Nearlyallofthecompanieswerelaunchedthesameyear,andL&Hhelpedcreateallofthosestart-ups.L&Halsorecruitedandtrainedtheirinitialemployees.Inadditiontosharingaddresses,manyofthecustomershavethesameofficersandnomineeshareholders.AsL&H'sstockpricefellfrom$72to$7,thecompanyissuedashortstatementsayingthatitiscooperatingfullywiththeSECinvestigation."Wearedeterminedtoresolvethesematters,"JoLernoutandPolHauspie,co-foundersandco-chairmenofthecompany,saidinthestatement.Acompanyspokesmansaidthatallofthecompany'srevenueandtransactionsinAsia"arereal,andweareconfidenttheywillbevalidatedassuch."TheSingaporecompanieswerelinchpinsinL&H'squesttobecomeaworldleaderintheexplosivemarketforspeech-recognitionandlanguagesoftware--productsthatallowcomputerstorecognizespokenwordsandturnthemintotext.L&H'ssoftwareproductsdominatetheU.S.retailmarketundersuchbrandnamesasL&HVoiceExpressandDragonNaturallySpeaking.Inthemostrecentyear,L&Hreportedthatitsworldwiderevenuerosemorethan60%,fueledbyhugegrowthinAsia.InSingapore,salessoaredto$80million,fromjust$29,000theprioryear.WithitsU.S.salesflat,Singaporebecamethecompany'slargestmarket.ButeightoftheSingaporestart-upshavehadfinancialtiestoaBelgianventure-capitalfundthathascloselinkstoL&H.Theventureoutfit,FlandersLanguageValleyFund,wasthebrainchildofL&H'stwofounders,Messrs.LernoutandHauspie,whoexercisedinfluenceoverthefund'saffairs.FLVFundowned49%stakesinfouroftheeightSingaporecompanies.TheotherfourcompaniesreceivedcashfromFLVFundinlate1999,whichtheyusedtopaytheirbillstoL&H,theoutsideL&Hspokesmansays.Thecompany'sauditcommitteehaslauncheditsowninvestigationwiththehelpofoutsidelawyers,aimingtoallayinvestorconcernsaboutitssalesinKorea,whichhaveshownspectaculargrowthsimilartothatinSingapore.LastAugust,thecompanyreplaceditschiefexecutive,GastonBastiaens,althoughL&Hsaidthemovewasn'trelatedtoquestionsaboutitsAsiansales.JohnDuerden,thenewlyappointedCEO,saidinacompanystatement,"Wehavenotyetreceivedtheresultsof[thespecial]audit,butwelookforwardtoitscompletionattheearliestpossibledate."L&Hwasstartedin1987byMessrs.LernoutandHauspie,entrepreneurswhohadavisionofcomputersthatcouldunderstandthehumanvoice.TheduobecamemultimillionaireswhenthecompanybecameBelgium'sfirsttogopublicontheNasdaqinlate1995.Atitspeak,thecompanybrieflyboasteda$10billionmarketcapitalization.Messrs.LernoutandHauspiebecamecelebritiesinBelgium,asmallcountrynotknownasatechnologyhotbed.


ButshortsellersandothercriticslongsaidthatL&H'sgrowthwasquestionable.Thecompany,theyclaimed,cloudeditsfinancialresultsthroughserialacquisitionsandartificiallyboosteditsgrowththroughtransactionswithfirmsthathaveclosetiestoMessrs.LernoutandHauspie.Asrecentlyasthreeyearsago,salestosuchrelatedentitiesaccountedfornearly22%ofthecompany'srevenue.InexplainingitsgrowthinSingapore,L&H'sspokesmansaysitwasinterestedinexpandingitsproductstonumerousadditionallanguagesandapplicationsbutanticipatedthatthemovewouldbeexpensiveandrisky.So,thespokesmansays,thecompanydecidedinsteadtosetup"franchise"arrangements,inwhichitwouldselltheexclusiverightstoitstechnologyforaspecificapplicationorlanguage--suchasUrdu,commonlyspokeninPakistan.Theconceptwasthatoutsideinvestorswouldtaketheriskofdevelopingtheapplication,andL&Hwouldshare50-50infuturerevenue,.Meanwhile,L&Hwouldreceiveupfrontpaymentsfortheexclusiverights.Butratherthanselltherightstoalready-establishedcompanies,theL&Hspokesmansaysitrecruitedoutsideinvestorstosetupspecial-purposeentities.Thefirstsuchagreementswerestruckinthesecondhalfof1998withsevenstart-upsbasedatthesameaddressinArendonk,Belgium.ThosecompaniespaidL&H$21million,or10%ofitsglobalrevenuethatyear,forrightstolanguagessuchasCzech,PolishandFarsi.Thearrangementwentgloballastyear,whenL&Hsigneddealswiththe19Singaporecompanies,inadditiontofourmoreBelgianoutfits.L&HsaidthecompanychoseSingapore,inpart,becauseofthecity-state'sfavorabletaxtreatmentofhigh-techstart-upsanditsstronglawsprotectingintellectualproperty.Inthisfashion,L&HsaysitsoldrightstolanguagessuchasUrdu,Malay,Taiwanese,Armenian,ArabicandVietnamese.Sevenofthecustomercompaniesalsopaidforthetechnologytodevelop"cross-language"versionsofL&Hsoftware,whichworkbytranslatingbetweenlanguagepairsthatdon'tincludeEnglish,suchasItalianandJapanese.AnothersixcustomerslicensedL&Hmaterialforwhatthecompanycalls"intelligent-agent"applications,whichuselanguagetechnologyforimprovedsearchesoftheInternetandothergiantdatabases.Intotal,theAsianandBelgiancompaniespaidL&H$85millionlastyear,oraboutone-fourthofitstotalrevenueof$344.2millionthatyear.AccordingtoL&H'sdocuments,mostofthecompaniespaideither$3millionor$4millioneachfortheirrights.Thefeesdon'tseemtobecloselyrelatedtotherelevantpotentialmarketsize.Armenianrights,forexample,costmorethanPolish,eventhoughPoland'spopulationofabout39millionis10timesthatofArmenia,anditseconomyismuchmoredeveloped.L&Hsaidthelicenseswerepricedsimilarlybecausethecompanywasn'tsureaboutthepotentialmarketforagivenlanguageorapplication.Understandardaccountingpractices,suchatransactionshouldhavetobedisclosedinthecompany'sannualreport.ThenFLVFundsoldthestakesfor$11milliontoaKoreancompany,HumanInterfaceWorldwideCo.,latelastyear.HumanInterfacewasitselfastart-up,incorporatedjustthreeweeksbeforetheFLVFunddeal.HumanInterfacealsowasformedtocommercializeL&H'sspeech-recognitiontechnology.TheSeoul-basedcompanyhadnorevenueandafterninemonthsfromthetransaction,FLVFundhadn'treceivedanypaymentfromHumanInterfaceThreeHumanInterfaceofficials,includingitschiefexecutive,J.J.Cho,saidthattheyknewnothingaboutthetransaction.Mr.ChoandtheothertwoofficialsalsosaidtheircompanyhadnostakesintheSingaporefirmsanddidn'toweanymoneytoFLVFund.Inasubsequentstatement,however,Mr.ChosaidhehadcheckedwithHumanInterface'smajorityshareholderandconfirmedthatthecompanydidindeedowemoneytoFLVFund.L&Hhascharacterizedthestart-upcompaniesasindependent.ButL&Halsohasagreementsthatallowittoacquireatleastsomeandpossiblyallofthesecompaniesatanytime,atasubstantialpremiumovertheamounttheinvestorsinthecompanieshadpaid,accordingtotheL&Hspokesman.Sucharrangementscanbeusedtoallowacompanytooverstaterevenueandunderstateresearch-and-developmentexpenses.If,forexample,oneofthecompaniesissuccessfulandL&Hsubsequentlypurchasesit,L&Hwouldhavereceivedcreditlastyearforthelicensefeepaidbythenow-acquiredcompany.L&HwouldhaveavoidedcostlyR&Dexpensesintheinterim.Andbuyingthecompanywouldallowittowriteoffmuchofthepurchasepriceoveralengthyperiod,resultinginonlyasmallimpacttoearnings,whileleavingoperatingcashflowundiminished.L&HsaidtheintentofthisarrangementwasnottohideR&Dexpensesorboostrevenue.Theprimaryreasonforthebuybackclauses,hesays,istoprotectL&Hincaseoneofthestart-upsfailedtodevelopthesoftwareinaproperandtimelymanner.Then,presumably,L&Hcouldrecovertherightsthroughthebuyback.


Duringthelastfiscalyear,L&Hreportedapproximately$175millioninsalesrevenuefromitsKoreanoperations.L&Hengagedin"sales"subjecttowrittenandoralsideagreementsthatdidnotappearintheL&Hcontractfiles.Thesetermsincluded,insomeinstances,agreementsbyL&Hnottopursuecollectionoflicensefeesunlessanduntilthe"customer"generatedsufficientrevenuefromuseoftheL&Hsoftwaretocoverthosefees.TopreventuncollectiblereceivablesfromremainingonL&H'sbooks,therebyraisingquestionsaboutthequalityofthecompany'sreportedearnings,aseriesoftransactionswithfourKoreanbankswerestagedtogivetheimpressionthatthereceivableshadbeenfactoredtothosebanksonanon-recoursebasis.Infact,L&HenteredintosideagreementswiththebanksrequiringL&Htomaintainblockeddepositstocovertheamountsofthe"factored"receivables,whichthebankscouldapplytosatisfyanycollectionshortfalls.Thus,thesetransactionswereessentiallyfullysecuredloansfromthebankstoL&H,ratherthansalesofreceivablesfromL&Htothebanks.Inanotherschemetodisguisethatitsescalatingaccountsreceivabledidnotreflectgenuinesales,L&HKoreaarrangedtohavethirdparties"purchase"thelicensingagreementsfromtheoriginalcustomers.Thetransfereeswouldthenobtainloans,collateralizedbyL&HKoreaassetsbutnotreflectedinL&HKorea'sbooks,andusetheproceedstopayL&HKoreathroughtheoriginalcustomers.Bythismeans,L&HKoreawas,ineffect,payingdownitsownreceivables,whilecreatingtheappearanceofsuccessfullycollectingpaymentsfromcustomers.Butearlythisyear,withthefirminfinancialtrouble,theysoughtbankruptcyprotection.ABelgiancourtrejectedarequestfromforbankruptcyprotection,sayingthefirmhadn'tmetthenecessarycriteria.L&H,unabletowithstandmountingfinancialirregularitiesandbankpressuretorepayseveralhundredmilliondollarsinloans,filedforbankruptcy-courtprotectionintheU.S.andadmittingthatoveronethirdofitsrevenueinthepastthreeyearswasimproperlyrecorded.Atthatpoint,thecompany'sco-founder,PolHauspie,resignedasprosecutorsannouncedaprobeofthecompany,whichadmitteditmayhaveconcealedinformationfromitsauditor.

FinalSagaforL&H

Scansoft1,Inc.wonanauctionfortheremainingassetsofLernout&HauspieSpeechProductsNV,biddingabout$42million.InadditiontotheScanSoftdeal,L&Hsoldthreesmallerunitstothreeseparatebiddersforatotalof$4.8millionincash,plusassumptionof$2millioninincentivepayments.TheproceedsfromthelatestauctionfollowearlierauctionsofotherL&Hassets,andbringthetotaltoabout$150million.Butbecauseofoperationalandbankruptcyexpenses,lessthan$50millionislikelytoremaintorepaycreditorsowedmorethan$500million.Thecompany'sco-founders,JoLernoutandPolHauspie,arejailedinBelgium.

1 November 30, 2001


TheReginaCompany,Inc.1

InFebruary1989,twoformertopofficersofTheReginaCompany,Inc.pleadedguiltytochargesofmailfraudandsecuritiesfraud.Reginadeveloped,manufactured,andmarketedvacuumcleanersandotherconsumerproducts.TheirfraudulentactionscostRegina'sinvestorsmorethan$100million.ThetopofficerwasDonaldSheelen,age42,presidentandCEO,whotookoverthoseofficesin1984,whenheandJamesFlynnboughtReginainaleveragedbuyout(LBO)fromGeneralSignalfor$31.4million.Heownedalmost40percentofthestock.TheotherofficerwasVincentP.Golden,ChiefFinancialOfficer.Itwasapubliccompany,tradingintheoverthecountermarket.Ithad9millionsharesoutstanding.Sheelen'sinvestmentinthefirm,atahighof$17pershare,wasabout$61million.AnSECLitigationReleasedetailsSheelen'sfraudulentactivities:"...SheelenandGolden,alongwithotheremployees,devisedandimplementedaschemetoinflatetherevenuesandprofitsofReginainordertomeetcertainpredeterminedsalesandprofittargetsandpermitReginatoreportsteadilyincreasingsalesandearnings.Theschemeinvolved:(1)failingtorecord$13millionofproductreturns;(2)creatingfalseinvoicesandrecordinginexcessof$5millionoffictitiousrevenuefromthoseinvoices;and(3)inflatingprofitsbyinexcessof$3millionbyfalselyloweringthecostofgoodssold....SheelenandGoldencausedReginatoimproperlyrecognizeatleast$6millionofrevenuefromanumberof"ship-in-place"salesatatimewhenrevenueshouldnothavebeenrecognizedunderGAAP....(4)TopreventdetectionofthesepracticesbyRegina'sauditors,SheelenandGoldenmadeandcausedtobemadefalseandmisleadingstatementstoRegina'sauditors,andfalsifiedorcausedtobefalsifiedthebooks,records,andaccountsofRegina...Goldentheninstructedseveralmembersofhisstafftonotrecordacertainamountofproductreturns(forthequarterendedDecember31,1987)...theemployeesalteredRegina'scomputersystemtopreventreturnsfrombeingrecordedandcorrespondingcreditdocumentsfrombeingsenttothecustomersinvolved."

1 Business Week: September 16, 1996


"......InlateJuneof1988(justbeforethefiscalyearend),SheeleninstructedGoldentocreateenoughadditionalsalestomeetSheelen'ssalestargetfortheyearendedJune30,1988...afterdiscussionsbetweenGoldenandseveralmembersofhisstaff,Regina'scomputerprogramwasprogrammedtocreatefictitiousinvoicesduplicatingoneormoreordersthathadalreadybeenfiled....onthelastseveraldaysofJune1988,approximatelytwohundredsuchinvoices,totalinginexcessof$5millionwerecreated,andthosefalseinvoiceswerereputedassalesinRegina'sfinancialstatementsfortheyearendedJune30,1988.""Reginarecognizedrevenueontheship-in-placetransactionsatthetimeinvoicesweresent,priortoshipmentofgoodstothecustomer.Regina'spolicyinpriorperiodswastorecognizerevenueuponshipmentoftheproduct...ship-in-placetransactionsdidnotqualifyforrevenuerecognitionunderGAAPbecausenoexchangehadtakenplace,risksoflossandrightsofownershiphadnotpassedfromReginatocustomers,andtherewasnotanypurposeforstructureinthetransactionsasship-in-placetransactions."Then,inanefforttokeeptheauditorsfromblowingthewhistleonReginainSeptember1988,SheelenandGoldenorallypersuadedtheauditorsthat:1.Therewasonlyoneship-in-placesalestransaction,namely,thetransactionthattheauditorshaduncovered2.Managementdidnotrecordthepropersalesreturnsbecausemanagementdidnotbelievethenumberswereaccurate3.TheissuanceoffalseinvoicesduringlateJune1988wasduetocomputererror


OnSeptember15,1988,SheelenattendedameetingofmarketanalystsandinvestorsinNewYorkCity.Inresponsetoquestionsraisedduringthemeeting,SheelenfalselytoldtheanalystsandinvestorsthatReginawouldreportanincreaseinsalesforthequarterendedSeptember30,1988.Butthepressuremounted,andSheelencavedin.AftermeetingwithGoldenonSeptember20,1988,anddiscussingthecontinuationofthefalsifyingofthebooksandrecordstomeetthesalestargetfortheSeptember30quarter,SheelenandGoldenagreedtodisclosetheinaccuracyofthefinancialstatementstoSheelen'soutsidecounsel.ThistheydidinthelateafternoonofSeptember20,buttheywerenotentirelyhonestwiththeircounsel:(1)theyattributedthe"inaccurate"salestocomputererrors,(2)theyexplainedthefailuretorecordreturnstotheirbeliefthatthenumbersweresohightheyjustcouldnothavebeenaccurate,and(3)theyhadonlyrecentlydiscoveredtheerrorsasaresultofGolden'spersonalinvestigation.Followingthemeetingwithcounsel,SheelenissuedapressreleasethatexplainedthelowersalesfortheSeptember30quarterasbeingtheresultofa"recentorderslowdown;variousadjustmentsincludingalargevolumeofreturns;andsomeproductiondelays."ThereleasestatedthatReginawouldshowalossforthequarter.Thereleasewas,therefore,lessthanhonest,andlessthancomplete.Thenextmorning,SheelenandGoldeninformedtheauditorsofpartofthestory,stillmaintaininginthatmeetingandforthenextfewdays,thattheerrorswereduetothefaultycomputerandtomanagement'sbeliefthatthesalesreturnswerenotaccurate.Finally,therooffellin:thestock,tradingat$17theweekbefore,collapsedtoaround$4.Sheelenresignedindisgrace.Weretheretelltalesignsevidentfromaclosescrutinyofthefinancialstatementsatleastoneyearbeforethecollapse?


CouldinvestorshaveforeseenthecollapseofthestockofReginabeforeSeptember20,1988?Therewereobviousredflagsinfiscal1988'sannualreportthatshouldhavealertedanalyststoimpendingtrouble.Thosesignalswereevidentalsointhethirdquarterreports.Grossprofitpercentageincreaseddramaticallyoverthefiscalyearsended1986,1987,and1988.Inconjunctionwiththelargeincreasesininventories,theimprovementsingrossprofitpercentagelookedsuspicious.Barringunusualcircumstances,thepercentageofgrossprofittosalesshouldremainaboutthesamefromyeartoyear.Onthisassumption,auditorsareabletotestthereasonablenessoftheclosinginventoryfigurebycomputinggrossprofitasapercentageofsalesforthecurrentperiod,andcomparingthispercentagewithgrossprofitpercentagefromtheprioryearoryears.Alargeincreaseinthepercentageofgrossprofitwouldsuggestthepossibilityofinventorymanipulation.Theinterplaybetweenhighergrossprofitandhigherinventoriesistheclassicplayingfieldforfraud.ThemanipulationsbeganwithMcKessonRobbinsin1939[andagainin1999],andincludesuchplayersasEquityFunding,Cenco,Mattel,CrazyEddieandZZZZBest.Thedisproportionateincreasesininventoryvs.salesraisedefiniteredflags.Comparingfiscal1988and1987,totalendinginventoriesgrew99%,butsalesincreasedonly41%.Theimprovementsingrossprofitpercentage,coupledwiththegrowinginventories,raisequestionsastowhethertheincreasesininventoriesarefictitious.Thisshouldhaveledinvestorstofieldinvestigations;contactingretailerswouldhaverevealedconsumerreturns,productdefects,andretailerdissatisfaction.Analysisofthecomponentsoftotalinventoriesledustofurtherquestions.Comparingtheendoffiscal1987and1988,rawmaterialsincreased97%,workinprocessgrew551%,andfinishedgoodsrose74%;itappearsthattheCompanywasbuyingrawmaterials,thatalotofproductswereinthepipeline,andthatunsoldfinishedgoodswerepilingup.


Accountsreceivablewasgrowingmuchfasterthansales.Betweenfiscal1987and1988,endingaccountsreceivablegrew84%,comparedtothe41%increaseinsales.Wewouldaskquestionslike"Hadthecompanyshippedtocustomerswithextendedterms,orwiththerightofreturn(whichisreallynotasaleatall)?HowcreditworthyaretheCompany'scustomers?"Whilefixedassetswereincreasing,repairsandmaintenanceanddepreciationexpenseweredecreasing.Betweentheendoffiscal1987and1988,thecostofproperty,plant,andequipmentincreased41%.Atthesametime,maintenanceandrepairsexpensedeclined22%,anddepreciationexpensedeclined25%.Thisshouldleadtoask:"IstheCompanyreducingitsdepreciationratesinordertoshowhigherearnings?Doesthedeclineinmaintenanceandrepairsexpensesignalneglect,oranattempttoimproveearnings?"In"AMessageToOurShareholders,"thechairman,DonaldSheelen,wrote:"Itfeelsrealgoodtofinishfiscal1988andtobethankfulthatyourcompanyachieveditsbestyearever....Reginahasgonefrombeingthe'runt'ofthefloorcareindustryintheUnitedStatestobeingonthevergeoftakingovertheNumber1spot....Bythetimethisreportreachesyou,weshouldbeonthevergeofmakingpublicannouncementswhichwebelievewillverymuchenhanceourgrowth."OnSeptember27,1988,Mr.Sheelenresigned.TheannouncementsmadeonSeptember27,1988werenotquitewhatMr.Sheelenhadinmind,buttheyshouldnothavebeenashocktoastuteanalystswhopaycloseattentiontofinancialstatements.

end


CigaretteRevenueRecognition

InSeptember,RJRNabiscodeclaredthatitwouldendthepracticeindomesticcigarettedistributionknownastradeloading.Astartlingnumberwasattachedtothisstatement:Thecompany,asaresult,wouldforgo$340millioninoperatingprofitsthisyear.Evenso,thenewsreceivedonlyroutinepresscoverageandcouldnothaveimpressedmostreadersashavingdeepsignificance.ButwhenyoufocushardonwhatRJRhasbeendoingoverthepastdecade,itaddsuptoanearthshaker.Tradeloadingisacrazy,uneconomic,insidiouspracticethroughwhichmanufacturers-tryingtoshowsales,profits,andmarketsharetheydon'tactuallyhave-inducetheirwholesalecustomers,knownasthetrade,tobuymoreproductthantheycanpromptlyresell.RJRengagedinthispracticeaggressivelyenoughoverthepastfewyearstooverstateoperatingprofitsinitstobaccodivisionbyanestimated$250million.TheotherfivemajorU.S.cigaretteproducerswereinthisgamealso.Intotaltheindustryappearstohaveexaggeratedoperatingprofitsbyasmuchas$600million.Unawareofthis,shareholderswererepeatedlymisled.Atleastsomeoutsidedirectorshadnoideathattheircompanieswerepuffingupprofits.Oneoftheworld'spresumablysavviestinvestors,KohlbergKravisRoberts,hadonlyafuzzyunderstandingofthisproblemwhenitagreedinlate1988tobuyRJRforarecord-shattering$25billion.AndthosewhoboughtRJR's$4billionjunkbondofferingslastspringwereleftinthedark.RJRexecutivesdonotdenythatthepracticeoftradeloadingwasmisguided.That'swhynewmanagementhasstoppedthegame.NeitherdotheycontestFORTUNE'Sestimatethatthecompanyaddedabout$250milliontoprofitsoverthepastfewyears.ButRJRmaintainsfirmlythattheprofitsarosefromlegitimatesales,bookedaccordingtogenerallyacceptedaccountingprinciples.Theprofitswerespreadacrossseveralyears,executivespointout,andwere"immaterial"inrelationtothehugeoperatingincomeRJRwasreporting-$2.8billionin1988alone.Besides,theyadd,tradeloadingiscommon.Asforlastspring'sbondissues,RobertSpatt,ofSimpsonThacher&Bartlett,alawfirmthatrepresentsKKR,saysthatdisclosureofthetradeloadingwasnotcalledfor.KKRwasjustthenbeginningtopindownthedimensionsoftheproblem,hesays,andhadnonotionitwouldculminateina$340millionsolutionafewmonthslater.FourofRJR'scompetitors-PhilipMorris,Brown&Williamson,Lorillard,andLiggett-refusetotalkabouttradeloading,pleadingantitrustproblems,theconfidentialityoftheirmarketingstrategies,andyounameit.PhilipMorrisistheindustryleaderwithabout40%ofthemarket,andRJRissecond,claimingithasupwardsof31%.CharlesMullen,theCEOofAmericanTobacco,theleastactivepractitionerofloading,saysheisgladtoseethisweedpatchthinningout.Theshameoftradeloadingisthatsomanybusinessmen,inandoutofthetobaccoindustry,acceptitasnecessaryifcertain,quarterlyfinancialobjectivesaretobemetoraparticularpicturepaintedforinvestors.Butwhena$340millionannouncementlikeRJR'scomesalong,thepracticeisexposedforthegrossdeceptionitis.Whetherthisacutecaseofmanagedearningsamountstoaviolationofthesecuritieslawsisanotherquestion.Themanagementofearningscanbesmellybutpermissible-orjustplainillegal.TheuncertaintyinthisinstancebringstomindaMichaelKinsleylineintheNewRepublic:"Whenwrongdoingisexposed,therealscandaliswhat'slegal."TRADELOADINGisakindofeconomictreadmill.Inthefirststep,manufacturersinducewholesalerstobuymorecasesofaproductthantheyreallyneed.Theinducements-pricediscounts,forexample-arecalledthe"push,"andthewholesalerslovethem.Nextcomesthe"pull"-promotionsattheretaillevel,alsofinancedbythemanufacturer,tohelpthewholesalerunloadthosemountainsofboxesstackedonhisfloor.Ifyou'veeverseen$2-offstickersonacartonofcigarettes,youwerelookingatapull.Pushesandpullsarecostlyenoughforthemanufacturer,butsupposeheistryingtoworkthismagicinabusinessliketobaccowithcertaintroublesomecharacteristics.First,cigaretteunitsalesaredecliningintheU.S.;thatmakesthepullmoredifficulttopulloff.Second,cigarettemanufacturersmustpayfederalexcisetaxesof16centsapackonthegoodstheyshiptothe


wholesalers,whichmeanstheyautomaticallyincurasizableup-frontcostwhentheypadvolume.Third,thisindustryhasafull-returnpolicyforcigarettesthemanufacturerregardsasstaletosell,typicallythosethataresixmonthsold.Whenthebadstuffcomesback,themanufacturercanatthatpointapplyforanexcise-taxcredit.Butinthemeantime,ofcourse,hehasincurredtheexpensesofproducingandinducingthesaleofcigarettesdestinedtoreturntohim.Ifhehasmanagedthisexercisewellenoughtoshowthebogusprofitsheisafter,hewillalsobeliableforincometaxeshewouldotherwisenothavetopay.Alas,thiswholeprocessisaddictivetoanextreme.IfamanufacturerloadsupthetradeinthefourthquarterofyearAandtherebyinflatessales,profits,andunitshipments,hewill,intheinterestsofcontinuingtolookgood,bepowerfullytemptedtorepeattheexerciseinthefourthquarterofyearB.Inanindustryshowingunitgrowth,hemightsettleforsimplymatchingthefirstyear'sload.Iftheindustryisdeclining,orifthemanufacturerislosinggroundtoadespisedcompetitor-asRJRhasbeendoingtoPhilipMorris-heisapttobeseducedintoincreasingtheloadyearafteryear.Bythisstrategyhedisguisestheextenttowhichheislosingbothhiscustomerbaseandmarketshare.Hearingabouttradeloadingrecently,CliffordMullen,anexcise-taxexpertintheU.S.Treasury,sizedupthefactsandcutthroughthesmoke:"It'slikegettinginwithaloanshark."ThehugetradeloadingnumbersthatRJRdisclosedonSeptember21suggestthatthecompany'stobaccomanagershadlongbeenscramblingtoavoidbrokenthumbs.Forperspective,considerthatthecurrentmanagementbelieves41/2daysofstockatthewholesalelevel,orabouttwobillioncigarettes,tobeideal.Butatthestartof1989,RJRhadanexcessof18.5billioncigarettessittingincustomerwarehouses,orclosetosixweeksofsurplussupply.Throughacombinationofforces-thenormalrunoffoftradeinventories,somereductioninshipmentsbyRJR,andmorereturnedcigarettesthanusualtheexcesshadbeencuttoaboutonebillioncigarettesbythedayofthecompany'sannouncement.Buthadthecompanyfolloweditspastpracticeofloadingupthetradeattheendofboththethirdandfourthquartersandofrepeatedlyuppingtheante,byearly1990theexcessinventorieswouldhavebeenbackuptoahighnumber,perhapsevenmorethan18.5billion.Enough!Thenewmanagementdecided.Wewi11notshipthisload.Thus,itquitcoldturkey.Thesefactsilluminatethefinancialequation:Ifnotshipping18.5billioncigarettesthisyearisgoingtobotheliminatetheexcessloadanddepriveRJRof$340millioninearnings,itfollowsinexorablythatshippingthatmanyexcessunitsinprioryearsproducedmillionsinearningsthatwereessentiallyartificial.Becausetheseprofitswererealizedwhencigarettepriceswerelowerthantheyaretoday,anestimateof$250millionformisbegottenpastearningsseemsreasonable.RJRdoesnotdisagreewiththefigure,althoughithardlyacceptsthecharacterization.Thecompanyconcedes,andwholesalersconfirm,thatRJRwasthebiggestperpetratoramongthesixbigU.S.manufacturers.Areasonableestimateforitscompetitors'tradeloadmightbeclosetofourweeksofgoods,ornearly30billionexcesscigarettes.FORTUNEestimatesthatthesecompaniesrecordedatleast$350millioninbogusoperatingprofitsastheloadwaspilingup.Putthesetwochunkstogetherandyouhavea$600milliontobaccoscam.ItishardtosayhowmanymoredollarsmighthavebeenaddedtothatpothadnotnewmanagementcomeinatRJRandnewprioritiestakenover.Asaheavilyindebtedcompany,RJRneedscashflowmorethanreportedearnings.Inthemanagementchange,KKRinstalledLouisV.GerstnerJr.aschiefexecutive,andoneofhisfirststepswastobringbackJamesW.JohnstontoruntheU.S.tobaccodivision.Johnston,43,aformerRJRmarketingexecutive,leftin1984forajobatCiticorp.Atall,outgoingsmoker-hedispatchednineSalemLightsduringatwo-hourinterview-JohnstonhadnotlikedtradeloadingwhenhewasoriginallyatRJR.Though"managementdisagreements"wastheofficialexplanationforhisdeparture,acolleaguewhoquitsoonafter-"Isaid,jeez,ifsomebodythatgoodisleaving,I'dbettergetoutofheretoo"-reportsthatthedisagreementsincludedtradeloading,whichJohnstonunsuccessfullyopposed.HelikedthepracticeevenlesswhenhecamebacklastJune,andthistimehewasinapositiontostopit.Thepopularityofloadingclearlyacceleratedin1982.AtthattimeRJRwasobsessedwithpreventingPhilipMorrisfromovertakingitinmarketshare,andthecigaretteindustrywashittingitswatershedintheU.S.,withunitsalesstartingtodecline.Thecompanieswerealsofacedwithadoublingoffederalexcisetaxesto16centsapackinJanuary1983.Wholesalersloadeduponinventoryin1982tryingtobeatthetax,andsodidretailersandsmokers.Thusasortoftradeloadingbogeywassetforfutureyears.Theindustrythensettledintoapricingpatternthatallbutinstitutionalizedtheload.Before1983themanufacturershadraisedpricesperiodicallybutonnofixedschedule.Inthatyear,however,theypostedanincreaseinJuneandanotherinDecember,andtheyhaveneverbudgedfromthattimingsince.Thewholesalersquicklycaughton,loadinguplikegangbustersbeforeeachincreasesotheycouldresellthecigarettestoretailersatthenew,higherprices.Nowaddictedthemselves,thewholesalersevenbegantobuildtheseincreasesintotheir


budgets.Byorchestratingthissmokefest,themanufacturerswerecondoningandencouragingtheload,willinglysharingtheirprofitswiththedistributorsinreturnforthisnice,big"trade-driven"fixintheJuneandDecemberquarters.ThatlefttheMarchandSeptemberperiodstobemanaged.Forthesetheproducersdevised-"manufacturer-driven"loads,inducedbyspecialpricediscountsandfavorablepaymentterms.Theoverallresult:alpineshippingpeakstowardtheendofthesecondandfourthquarters,smallerpeaksattheconclusionofthefirstandthird.ThetwomencallingtheshotsatRJRtobaccowereEdwardA.HorriganJr.,whoundervarioustitlesranthebusinessfrom1980toearlythisyear,andhisnextincommand,GeraldH.Long,whoretiredin1988.Long,61andchattyinretirement,venturesthatRJR'sdistributorinventorieswereatfivebillioncigarettesby1984.Buthealsosaysthatasthetradeloadgrew,thecompanylostahandleonhowbigitwas,becominguncertainastohowmanypackswerepilingupinwholesalewarehouses,asopposedto"sellingthrough"atretail.Hiscommentsrelatetoanindustrymystery:theactuallevelofretailsales,intotalandbybrand.Definitivefiguressimplydon'texistbecausesomanycigarettesareboughtatmomandpopshopsandnewsstandswherethereisnoscannertechnologyforcountingsales.Nonetheless,thetobaccocompaniesspeakauthoritativelyaboutmarketshare,typicallywithoutconcedingthehazinessoftheconsumptionstatistics.Ortheyusemanufacturers'shipmentstowholesalers-whichisaknownfigure-astheirbase.Theabsurdityofthatstatisticwhentradeinventoriesarebecominggiganticisobvious.Initsstatementstoshareholdersbetween1984and1987,RJRwascheerilychroniclingmarketshare,pointingouthowitrosefrom31.5%in1983to32.5%in1987.Inthebackofsomeannualreports,thoughnotall,shareholderslearnedthosepercentageswerebasedonmanufacturers'shipments.Tradeloadingwasnevermentionedasareasonfortheshareincrease.Spacingouthiswords,JerryLongsays,"Maintaininga32%marketsharewasavery,veryprimaryobjective."Why?"Becausethenourcommentcouldbethatwehadapproximatelyone-thirdofthemarket,"heexplains.Thatfigurewasimportanttoretailers,hesays,indecidinghowmuchdisplayspacetoawardamanufacturer,anditwasimportanttoWallStreetanalysts."Nobodyworriedwhetheritwasartificial,"Longsays,addingthatanalystsneverpokedintothepercentage,questioningwhetherasharepointortwomightbetradeloading.Despitehisbrandloyaltyto32%,LongsaysheandHorrigandidfromtimetotimediscussreducingthetradeload,whichwasbecomingexhaustinglyexpensivetocarry.Thepushandpullexpenseswereenormousinthefaceofdecliningunitsales,andreturns,alwayscostlytohandle,grew.HorriganandLongunderstoodthepathologyoftheloadproblem,butlikesmokersplanningtoquit,theycouldneverfindtherightday.Thenin1987,RossJohnson,atigerforcostcontrol,replacedTyleeWilsonasCEO.Ratherthanconfrontingthisburningissue,Johnsonseemsnoteventohavenoticedtheblaze.Hesaysthatformorethanayearafterbecomingboss,hedidnotknowtherewasatradeloadingproblem.LongbelievesJohnson'sattentionwasfixedelsewhere:"MyfriendRosssaid,'Jerry,youhaveonegreatbigmajorobjective,andthat'sproducingover$300millionaquarterinoperatingprofits.'"Doingthat,accordingtoLong,wasnotconsistentwithreducingtradeloading.Nor,itcanbenoted,wouldreducingtheloadhaveallowedRJR'sexecutivestomakethemostofthecompany'sgenerousincentivecompensationschemes.WHENLONGRETIREDinearly1988,hestillhadn'tfoundtherightday.ButHorrigan,readytoseizethemoment,askedLong'ssuccessor,DolphvonArx,togetthemonkeyoffRJR'sback.VonArxhadcomefromThomasJ.Lipton,whereteawastradeloaded.ButRJR'scigarettebusinesspresentedhimwithwhathecalledadoublewhammy:decliningunitsalesintheoverallmarketandslippageinRJR'smarketshare.Hehadapparentlynoticedthatthe32.5%sharewasnotasolidfigure.Thoughhedidn'thaveaprecisecount,vonArxbelievesRJR'sexcessloadatthebeginningof1988mighthavebeenaround14billion,achokingnumber.Sointhefirstquarterheconstructedathree-yearplanforgraduallybringingitdown.Shipmentswouldnecessarilybecut,butthehigher.pricesthattheindustrywasconstantlyimposingonsmokerswouldkeepsalesandearningsrising.VonArxpresentedhisplantoJohnsonandHorrigan,andthey,hesays,"boughtin."TheRJRboardofdirectorsheardabouttheprogram,gettingtheirfirstintimation,itseems,thattradeinventoriesweretoohigh.Treadingdelicately,thecompanytoldWallStreettoexpectsomereductionsinshipments-thoughnot,Horriganpointedout,anycutsinretailmarketshare.Withthat,vonArxputdistributorsonallocationinthesecondquarter,sothattheycouldnotloadupheavilyinadvanceoftheJunepriceincrease.Theyhowled.Butbytheendofthequarter,vonArxhadthetradeloaddowntoperhapstenbillionunits.Soonafter,histhree-yearplanwasderailedbythebiggestbuyoutinhistory.OnOctober20,RossJohnsonandamanagementgroupthatincludedHorriganannouncedtheiroffertobuythecompanyandsentKKRandahostofotherprospectivepurchasersscrambling.ByDecembervonArxhadleftthetobaccodivisiontobecomeCEOofanotherRJRoperation,Planters


LifeSavers.Horrigan,meanwhile,wasmaneuveringtokeephisjobinaKKRregime.Theloadproblemwasneglected.RJRdidnotputthetradeontightallocationinthefourthquarter,andas1989began,theloadwasupto18.5billionunits.NONEoftheprospectivebuyersofRJRgraspedthedimensionsofthetradeloading,andsomeplainlydidn'thaveaclue.Saysoneinvestmentbankertodaywhoplayedaleadingroleinthebuyout:"Tradeloading?Idon'tknowwhatthatis."Anotherkeyinvestmentbankercheckedwithhisstaffandfoundoutthatithadexaminedtheissueintheduediligenceprocess.Managementtoldthebanker'sstaffthatloadingwasprobablya$100millionproblem,nomore.VonArxsayshethinksthebest-informedshopperwasBrianLittle,ofthebuyoutfirmForstmannLittle.Little,whosefirmeventuallywithdrewfromthebidding,recallstodaythathecametothinkoftradeloadingasa"troubling,nagging,butknownelement,"defendedbymanagementasnecessary.Headds,"I'dsayweknewtherewereseveralhundredmillionsofdollarsoutinthefieldthatonecouldsayweren'treallysales."AndwhataboutthespecialcommitteeofRJRdirectorssetuptodoitsownduediligenceandassessthebuyoutproposals?Saysoneofthecommittee'sfivemembers,whoasksforanonymity:"Idon'trecalltradeloadingcomingout."Didhethinkthat18billioncigarettesintradeinventories,quarterlymake-your-numbersloads,andeffortstomaintainmarketshareartificiallyshouldhavebeensubjectsfortheboard'sauditcommitteeatsometime?No,hesays,"thatwasn'tanauditcommitteematter.Itwasaboardmatter.That'ssomethingthatsmacksofmanipulation."Emst&Young,whichwasRJR'sauditoruntilMarch1989,whenKKRmovedtheaccounttothefirmitusuallyengages,DeloitteHaskins&Sells,declinedtobeinterviewedongroundsthatitdoesnotdiscussanyclient'saffairs.AsforKKR,SimpsonThacher'sRobertSpattsaysthatwhenKKRwentintothebuyoutnegotiations,itknewfromarticlesinthepressthatwholesalersloadeduponcigarettesbeforepriceandexcise-taxincreasesandthatRJRindulgedinthepractice.Thefirmlearnedmoreintheduediligencediscussions,inwhichRJR'smanagerstookthepositionthatthis"accumulatedload"wassomethingtheyweregoingtodealwith.SaysSpatt:"1don'tthinkKKR-andquitefrankly,Idon'tthinkthecompanyatthattime-reallyknewtheprecisenumber.Ithinkeveryoneknewthatitwasabignumber,abigproblem.ButIdon'tthinktheperceptionwasthatitwasquiteaslargeasthecompanyultimatelyreported."Inanycase,hesays,KKRdidnotregardthisissueassomethingthataffecteditsopinionsaboutthefundamentalvalueofRJR.ImmediatelyafterKKRcompletedthefirststageofitsbuyoutinFebruary1989,itagainheardabouttradeloading.WordcamenotfromHorrigan,whowasunsuccessfulatimpressingtheKKRcrewandhadretired,butfromRJR'schieffinancialofficer,EdwardJ.Robinson,whohassincetakenthesamejobatAvon.SaidRobinsontoaKKRrepresentative:"Whatdoyouwanttodoabouttradeloading?"SpattsaystheKKRmanresponded,"We'renotinanypositiontotellyouwhattodo.Wearenottobaccooperators.Weneedtogetamanagementteaminplace,andwhenwedo,we'llmakeadecisionhowtodealwiththis."OnApril3,LouGerstnet'sfirstdayonthejob,hemetwithmanagerstogooverproblemsandissues.FirstonthelistwaswhethertokillPremier,thesmokelesscigarettethat-HorriganandRossJohnsonhadbacked-andthattastedsobad,accordingtothejoke,thatnobodywouldevenstealit.Gerstnerpronouncedthedeathsentenceandmovedontotheotherproblems,whichincludedtradeloading.Itdidn'tseemlikeabigdealtohim,Gerstnernowsays-"itstilldoesn't,infact"-butithunginhismindashewentforthtorecruitthemanhereallywantedtorunhisdomestictobaccobusiness.ThatwasJimJohnston,whofoundtheRJRchallenge"irresistible."Acomponentofthechallenge,thetwomenagreedastheytalked,wastradeloading.ArrivingatRJRonJuneI,Johnstongotreportsofthree-andfive-yearplanstobringdowntheloadandthoughteventhreeyearswastooslow.ByJulyIhehadthewholesalersonallocation.Healsotriedimmediatelytodeterminehowbigtheloadwas,butfoundthejobdifficult.SomesalesandmarketingpeopleweretellingJohnstonitwas13billion,others15billion.Johnstonthensentsalesmenintoeverycustomer'swarehouse,hesays,tocountcaseswithhandheldcalculators.Hearingreportsthatsomewholesalershadrunoutofroomintheirownwarehousesandrentedspaceelsewhere,thesalesmentriedtotrackdownthatmerchandiseaswell.Whentheroundupwasfinished,therewasthatnumbingnumberofwhatShakespearecalled"thouweed!whoartsolovelyfairandsmell'stsosweet,"whichisnotexactlytheodorJohnstondetected.BythistimeJohnstonwascomingtogripswithstatisticsonreturnedcigarettes.In1988,ayearinwhichRJRshipped177billionsmokes,about2.5billion,or1.4%,wereshippedbackbywholesalers.Thisyear,saysthecompany,thepercentagewillbehigher,thoughitdeclinestogivefigures.Aspotcheckofabigsmokingstate,Texas,revealsthatRJR,withits"one-thirdofthemarket,"accountedfor43%ofreturnsfromJune1988toJune1989.Theworstproblemaboutreturnsiswhattheyimplyaboutcigarettesthathavenotbeenreturned.


Inevitablythewarehousingofsmokesforlongperiodsleadstoconfusionaboutwhichblockofinventorycameinfirstandmustbesoldfirstsothatitwon'tgetstale.JohnstonsaysthatRJRhashadproblemswithstalegoodshittingthemarketandirritatingsmokers.Thestalenessquotientwasonhismindashedeliberatedhowtodealwiththeload.Johnstonfirstdecreedthatitwouldhavetobeeliminatedbynolaterthantheendof1990.Then,lyingawakeonenight,hethought,"We'vegottogetonwiththis."Earlynextmorning-thedatewasWednesday,September13-hecalledGerstnerandsaidhewasconsideringaxingtheload"rightnow,"assumingthemanagementgroupagreedthatsuddenactionwasfeasible.ByFridaymorning,whenGerstnerarrivedinWinston-Salemforapreviouslyscheduled'meeting,thegroup'sconclusionwasyes.GerstnerhadKKR'sapprovalbythattimeandhegavehisown."Itwasnot,"Gerstnersays,"aharddecision."ONETHINGmakingitrelativelyeasywasJohnston'sdiscoverythattheeffecton1989cashflowwillbe"slightlypositive"-orsomethingunder$20million-becauseofthecostsavingsthatcanberealized,forexample,fromsmoothingproductionschedulesandreducingpushexpenses.Post-buyout,RJRisaprodigiouslyleveragedcompanywhoseinterestcostswillpreventtheshowingofearningsforsometimebutwhoseneedsforcashareintense.Sointheorythedisappearanceof$340millioninreportedearningsmatterslesstoitthantheunlockingofachunkofcash.Themovetoforgothatmuchallatoncealsohasthelookofabigbath.Reducingtheloadovertimewouldhavestrungoutthefinancialeffects,creatingadragonsalesandearningsandperhapsdismayingcreditors.Notthattheyappeartotallythrilledtoday:ManyRJRbonds,afflictedbyjunkbonddisease,haverecentlyskidded.ThedecisiontokicktheloadinghabithasclearedJimJohnston'sagendaofahugedistractionandallowedhimtoreorderhisspending.Moneythatusedtogotothetradeinthepushwillnowbeallocateddirectlytoconsumerpromotions;timethatRJR'ssalesmenusedtospendstrokingwholesalerswillnowbelavishedonretailers.Hisorganization,saysJohnston,cansensethebenefitsahead.Hetalkslikeamanfromwhomahugeloadhasbeenlifted,nokidding:"Whatwehavedoneisarealstatementofchangeinemphasisanddirection.There'sprobablynosinglethingIcouldhavedonethatwouldhaveenergizedtheplaceasmuchasIthinkthishas."Johnston'smovehasgiventherestofthetobaccotradeanicotinefit.RJR'sannouncementonSeptember21cametoolatetoaffectthethird-quarterloadprogramsofitscompetitors.OnthatverydayPhilipMorrisnotifiedwholesalersofapricepromotion.Bynow,however,theotherfivecompanieshaveplayedfollow-the-leader,puttingthewholesalersonallocation.Thatimpliestheytoowillberenouncingtheloadoratleastcuttingitback.Iftheysticktothatintention,theirfourth-quartertobaccoearningswillsuffer.Lorillard,controlledbythecost-consciousTischfamily,hasindicatedtoWallStreetthatadecreaseisanacceptabletrade-offforbeingsuddenlyfreedfromatypeofpeerpressureitneverliked.PhilipMorriscannotbeaspleased,sinceitneedsreportedearningsfromitstobaccosidetooffsetthegoodwillwriteoffsarisingfromitsKraftmerger.ButtherealpainmayfallonBrown&Williamson,adivisionofBritish-AmericanTobacco,thecompanyunderattackfromSirJamesGoldsmith.FromBAT'sstandpoint,thisishardlyaconvenienttimeforB&Wtostoppaddingitsearnings.Buthowcanitdootherwise,whentherealitiesoftradeloadingarenowinpublicview?Thetrulyexcruciatingwithdrawalpainsarefallingonthedistributors.Theyhavetreasuredtradeloading-"grownaccustomedtoitscharms,"saysone.Many,infact,wouldbebreakevenoperationsormoneylosersiftheydidnotgetaquarterlysurgefromtheload.SaysPeterStrauss,aNewYorkdistributorandindustryleader:"Takethoseprofitsawaywithoutgivingussomethingintheirplaceandyou'vegotbloodinthestreets."Somedropsarealreadyvisible.WordisaroundthatatroubledLBOcompany,Southland,ownerofthe7-Elevenconveniencestoresandfivedistributorsthatservethem,ishavingpoorlucksellingoffitsdistributorsbecausetheirprofitsdependsoheavilyontradeloading.ForRJR,traderelationsareapttobeanimmenseproblem,andJohnstonagreesthatsomefencemendingwillberequired.ButhehopestoannouncebyDecemberaninnovativetradeprogramthatwillrewardwholesalersinnewandacceptableways.THEMORECRITICALissueforRJRmaybeconvincingsomeclosereadersofitsfilingswiththeSECthattheyhavenotbeenmisled.FromMarch1989untilSeptember,RJRpublishedone10-Kannualreport,two10-Qquarterlyreports,onemergerproxy,andthreebondprospectuses.Inthequarterlies,RJRnotedthat"aprogramtoreducefieldinventories"hadcontributedtolowerunitvolumein1989butsaidnothingelseabouttradeloading.Theotherdocumentsdescribed1988resultsandincludedjustonesentenceontradeloading.Itsaidonereasoncigarettevolumefellduringtheyearwasaprogram"torealigntradeinventories."Wouldnotareaderassumefromthatexplanationthattradeinventorieshadfallen,insteadofrisingto18.5billioncigarettes?Theproxyandprospectusesalsorepeatedthat32%marketsharefigure,asin"domesticmarketsharefor1987,measuredonmanufacturers'shipmentbasis,increasedto32.5%."Spatt,KKR'slawyer,defendsthewordingtotally:"Themarketsharefigureiscorrectlystatedandsoisthecommentabouttradeinventories.Withoutthe1988program


tobringthesedown,theyear'sshipmentswouldhavebeenhigherandtheloadattheendoftheyearwouldhavebeengreaterthanitwas."JimJohnstontalksaboutmarketsharefiguresthesedaystoo,butwithextremecare.HesaysRJRbelievesitsshareofsalesattheretaillevelisabout31.6%.Nextyear,assumingthatthedamnedspotcalledtradeloadinghasbeenrubbedfromRJR'ssmokingjacket,cigaretteshipmentsandsaleswillberoughlyequal-andthenperhapswewillknowwhohasorhasn'tgotathirdofthemarket.

end


ZZZZBest1

LarryGraymaywellbetheworld'sunluckiestaccountant.Overweightandaffable,hewastheErnst&WhinneypartnerinchargeofauditingBarryMinkow'sZZZZBest."Itcouldhavehappenedtoanyofus,"saidapartneratarivalauditfirm.GrayrantheSanFernandoValleyofficeofErnst&Young.BarryMinkowwasaremarkablecombinationofinnocenceandsophistication,geniusandilliteracy,youthandmaturity.Mostofhisvictimsareinvestorsandlenders,wholostmorethan$100millionastheresultofBarry'shandiworkandtheunwittingcomplicityofsomanylawyers,accountantsandinvestmentprofessionals.Theirsisacautionarytaleforallofus.In1986LarryGraynoticedthatZZZZBesthada$7millioncontracttorestoreadamagedbuildinginSacramento.Sensiblyenoughfortheindependentauditorofacompanyabouttosellstocktothepublic,Graydemandedtoseeit.Barryrespondedcharacteristically.Hestalledandhelied,claimingthathiscontractsrestrictedaccesstothejobsforliabilityreasons.ButstockbrokerRooneyPacewasthreateningtoholdupitsplannedZZZZBeststockoffering,andErnstwasn'tgoingtocertifythecompany'sfinancialstatements.Reluctantly,BarryagreedtoletthemvisittheSacramentojob.OfcoursetherewasnoSacramentojob.ButifZZZZBestneededonetoshowitsauditors,itwouldjusthavetobefound.Barrydispatchedtwoofhislieutenants,TomPadgettandMarkRoddy,toscopeoutalikelybuilding.Theymadeagoodteam.Padgettisanavowedwhiteseparatist,andnoonecouldbewhiterthanRoddy,asixfoot1inch,275poundalbinowithaconvictiononacocainecharge.PadgcttcalledhimtheUWM,theUltimateWhiteMantodistinguishhimfromanotherMinkowaidenamedMark.OnceinSacramento,PadgettandRoddyquicklydiscoveredtherewasonlyonebuildingbigenoughtoharbor$7millionworthofdamage:thetowering300CapitalMallbuilding.PadgettandRoddytookadeepbreathandtoldthebuildingmanagerstheyneededtoleaseaconsiderableamountofspace,"butourinvestorscan'tcomeexceptonaweekend."Infact,Gray'svisitwasscheduledforNov.23,aSunday.ZZZZBesttoldGraythiswasinordertoavoidinterferingwithongoingwork,butactuallyitwastoavoidchanceencounters,sinceevenacasualwashroomconversationcouldtorpedotheirplan.ToPadgett'sandRoddy'srelief,theygotthekeys.OnNov.17,aMonday,theywentwithMinkow'sright-handman,MarkMorze,tooneofthoseinstantofficeplaces,wheretheyplunkeddown$2,000incash.OvernightsomethingcalledAssuredPropertyManagementsprangintobeing,completewithoffice,furniture,phonesandcopyingprivileges.Assuredexistedonlyonpaper,ofcourse,butitwassupposedlyinthebusinessoflookingaftertheinterestsoftheinsuredpartyinvariousrestorationjobs.ItenabledRoddyplausiblytostandinforthebuilding'sowners,managersandinsurers,whocouldprovetroublesomeifcontacteddirectlybytheauditors.Roddyandcompanyputupabigmapwithpinsinit,signifyingallthejobsAssuredwas,assuring,andtheinstantofficesuddenlylookedconvincing.Thingswerecomingtogether,butbeforeGrayandaHarvard-trainedsecuritieslawyernamedMarkMoskowitzheadedforSacramento,theyaccededtoBarry'sdemandforsecrecy.Bothpledgedinwritingnottodisclosethesitetoanyone,evenattheirownfirms:"Wewillnotmakeanyfollow-uptelephonecallstoanycontractors,insurancecompanies,thebuildingownerorotherindividuals(otherthansupplierswhosenameshavebeenprovidedtothisfirmbytheCompany)involvedintherestorationproject...."Inshort,theypromisednottomaketheslightestindependentefforttodetermine

1 Forbes October 2, 1989


whatwasgoingon.OnSaturday,Nov.22Morzeflewuptocheckthingsout.Allseemedwell;Barry'smenevenhadtheforesighttomemorizetheroutebetweentheairport,Assured'soffices,andtheCapitalMallbuilding,becausetheyknowthey'dhavetoseemasifthey'dmadethedrivemanytimesbefore. Barrycalledfrequently."ThisistheSuperBowl,"hetoldPadgett."It'slikeafieldgoalwithnotimeleftontheclock.""I'mgoingtocenteritandMorzeisgoingtokickit".OnSundaymorningitwastimetoputtheirplanintoaction.At10:20a.m.RuddyapproachedsecurityguardTomMyersattheCapitalMallbuilding."Listen,wouldyouliketomakeanextra$50foryourself?""WhatdoIhavetodo?""JustbenicetosomepeopleI'vegotcomingthroughherelateron,guysnamedMarkMorze,LarryGrayandMarkMoskowitz.""Well"saidMyers,acceptinga$50bill,"beingniceispartofthejob."Roddyexplainedthattherewasa"bigdeal"goingon,andhewantedhisgueststreatedlikeimportantpeople.Anhonestman,Myersnoddedandthenfiledanincidentreportwithhisemployer,BurnsInternational.Healsoturnedinthe$50.Upstairs,RoddyandPadgettpostedZZZZBestsignswherevertheycould,leftaZZZZBestTshirtinoneoftheemptyroomsandswipedasetofblueprintstocarryaroundlikesomesortofmagicwand.Thenitwasonlyamatteroftime.Roddysatdownintheconferenceroomofhisfakeofficesandwatchedafootballgameontelevision.BackinLosAngeles,Gray,MoskowitzandMorzecaughtaflightnorth.InSacramento,theyvisitedthesupposedofficeofAssuredProperty.Thentheydroveovertothe300CapitalMallbuilding.ItwasSunday,andtheplacewasdeserted.MoskowitzandGraywerewearingidioticlittleZZZZBestbadgeswiththeirpicturesonthem."EverytimeItalktoaccountantsandlawyers,Igetintotrouble,"Roddyjoked."Hey,we'reonyourside,"theyreplied..Roddy,freeonbailafterhisdrugarrestinNewMexico,laughed.Inthelobby,securityguardMyersdutifullyexchangedpleasantrieswithRoddyandMorze,whoseemedcompletelyathome.Roddysignedinat1:15p.m.GraywroteinamemototheZZZZBestfilethenextdaythatthetourfirstwentuptothe17thfloor,whichwasoccupiedbyalawfirmhelatertoldpolicethattheyalsovisitedfivelowerfloorschosenatrandom."ZZZZBest'sworkissubstantiallycompleteandhaspassedfinalinspection,"hewrote."Finalsignoffisexpectedshortly,withfinalpaymentduetoZZZZBestinearlyDecember."Grayaddedthat"ThetourwasbeneficialingaininginsightastothescopeofthedamagethathadoccurredandthetypeofworkthattheCompanycando."RoddyandPadgettcouldn'tbelieveit.GrayandMoskowitzhadwalkedthroughabuildingthathadabsolutelynothingtodowithZZZZBest,andtheywerecompletelyfooled.SuchsuccessesmadeitpossiblyforBarrytoraisemoreandmoremoney,whichheneededtokeephisPonzischemagoing.OnNov.28hemetwithexecutivesfromUnionBankofLosAngeles.Asinsomanyofhisrelationships,thebalanceofpowerinthisonehadsubtlyshifted;nowthebankerswerecomingtohim.Barry


toldthemhewantedtoborrowmorecash.Theylenthimanother$300,000.Barryknewhewasabouttohandthebankersanenormousdepositfromtheupcomingstockoffering,andheintendedtogetalotoutoftheminexchange.Healsoknewenoughnottoaskforitallatonce,butratherinincrements.Hehadalreadyborrowed$900,000.OnDec.4,aThursday,Barryandthebankersmetagain.Hewasinfinefettle,andtoldthemZZZZBesthadjustbeenawardedan$8.2millionrestorationjobinSanDiego,aswellasseveralotherinsurancejobs.Hewentontosaythatpublicitysurroundinghisstockofferinghadbroughtin"morebusinessthanIknowwhattodowith,"andthatheneededmoremoneytocapturetheseopportunities.Heaskedtoborrow$1.3millionplusa$7millionlineofcredit.OnDec.9notaminutetoosoonforBarry'sravenousmoneyeatingenterprise,theSECdeclaredtheZZZZBestofferingeffective.UnionBanksoongrantedthe$1.3millionloan.Finally,onDec.16,thegloriousmomenthadarrived:Barrywashandedacheckfor$11,550,000,thenetproceedsfromthestockoffering.Hegotthe$7millioncreditlinefromUnionBanklaterthesameday.ThusZZZZBesthauledinmorethan$21millioninasingleday.Grownupsweren'tjusttakingBarryseriously.Nowtheyweretreatinghimwithrespect.OnSaturdaynight,hecelebrated.ZZZZBestheldaChristmaspartyforbetween500and1,000guestsattheslickBonaventureHotelindowntownLosAngeles.Theeventwasacombinationrevivalmeeting,salesrallyandAcademyAwardsceremony.Asusual,noexpensewasspared.Barrywasinasnow-whitetuxedo,whiteshoesandblacktie.Hishairwascutrazorsharp,andtherewasn'ttheslightesttraceofnervesabouthim.Whenthecrowdchantedinunison,"Barry...Barry...Barry..."heseemedonceagainatthecenterofsomesinisterpersonalitycult,andhisexaltedpositionbeforetheadorationofhisminionssenthimintoecstasies.Alas,theaccountantsremainedcurious.Ernst&Whinney'sLarryGraywasdemandingtoseeanotherbigjob,thistimetheoneinSanDiego,andsoinJanuaryof1987,PadgettandRoddysalliedforthonce."ItwaslikewatchingLaurelandHardy,"saysonemanwhodealtwiththem."RoddywoulddoallthetalkingwhilePadgettwouldwalkaroundlookingataguncatalog,lookingatmachinegunsandbazookas.Hehadthethinghighlightedinyellowink."Thetroublewas,Barryforsomereasonhadtoldthelawyersandaccountantsthatthe$8.2millionrestorationjobinquestionwasinNationalCity,justoutsideSanDiego.WhenPadgettandRoddygotthere,thereweren'tanybuildingsthatcouldevenremotelypassforastructureinthemidstofan$8millionfacelift.Thetwopartnersincrimewereundaunted.TheycheckedintotheswankoldHoteldelCoronado,acrossthebayfromSanDiego,foundthemselvesacommercialrealestatebrokerandthenlaidout$22,560forayear'sleaseonasmallofficeandindustrialspacebytheMiramarNavalAirStationnearthecity.Asforthelittlediscrepancyaboutwherethejobreallywas,they'djustsay,"WellthesuppliesareinNationalCity,butsee,thejob,that'sactuallyinSanDiego."Tofillthewarehouse,theyorderedin$168,000worthofthecheapestcarpettheycouldget.BynowitwasearlyFebruary,andtimewasgettingshort.ThiswarehousewastobethelocaloutpostofRoddy'sphonyAssuredPropertyManagement.TheyputupamapandcircledallthesupposedSanDiegoareajobs.Theythrewpopcornalloverthefloor,tomaketheplacelooklivedin.ThentheywentovertoChristopherPenrose,whofiguredtheywerenutsbutwhostillhadabuildingtolease.Penroseisahandsome,cheerful,sandy-hairedguywhowasintrainingforatriathlonwhenRoddyandPadgetstumbledintohislife.HewasworkingforMerrillLynchRealtyrepresentingtheFederalSavings&LoanInsuranceCorp.initssullenreceivershipofthebrandneweight-storystructureat1551FourthAvenueinSanDiego.ForFSLICthebuildingwasjustanotherheadacheintheongoingcollapseofthenation'ssavingsandloan


industry.ForZZZZBest,itwasagodsend.Buttherewasnotimetowaste;LarryGrayhadsignedanotherconfidentialityletter,andwouldsoonbeonhisway.RoddyandPadgettwenttowork,claimingtheyweresettoleasemuchoftheFourthAvenuebuilding."Ourinvestorsarecominginthisweekend,"theysaid,rememberingtheirlinesfromSacramento.Alltheyneededwasthekeys,sotheycouldshowtheirbackersaround.Asexpected,theygotthem.Eventsmovedfast.OnFriday,Feb.6,GrayandhisfamilyarrivedinSanDiego,combininghisvisittothejobwithafamilyouting.Earlythenextmorning,theZZZZBestgangwentintothebuildingandputupZZZZBestsignsandphonycontractors'permits,justastheyhadinSacramento.Theytookdownany"ForRent"signs."PoorLarryGray,"oneoftheconspiratorssaidlater."They'llaskhim'Howdoyouknowthisisacourtroom,Larry?Howdoyouknowyouwereworkingforanaccountingfirm?Howdoyouknowyou'reyou?'"SoonMarkMorzecollectedGrayanddrovehimovertotheAssuredoffice,whereaZZZZBesttruckhadbeencarefullyparkedoutfront.Grayseesrollsandrollsofcarpetandpadding;Morzeexplainsthatthebroadloomisintendedforabuildingdamagedbybothfireandwater,whichtheywillvisitnext.Graytakesnotessohewon'tforgetanything.ThenheandMorzedriveovertoFourthAvenue,wheretheyaregreetedbyRoddy."How'reyoudoing,Larry?"Roddyasksjovially."Gee,lookslikeyou'refollowingmealloverthestate."Atthatverymoment,somerealcontractorsdroveuptothebuilding,threateningtoruineverythingbytheirmerepresence.Now,MarkRoddyisnotperfect.Hehasacriminalrecord,heeatstoomuchandhecanhaveanastytemper.Butatthatparticularmomenthewasimpeccable.Heimmediatelyranoverandtoldthecontractorsthatheandhispartywerebuyingtheplace.Heevenfoundoutwhatfloorstheywereworkingonandmadesuretoavoidthem.Theneverybodywentinside.ToGray'suncriticaleye,theworklookedsatisfactory,andnowonder.ZZZZBesthadn'tdoneathingtoit.ApparentlyGraysawsomefinishedspace.Hewastoldthiswasdoneforprizedtenantswhogotfirstpriority.HealsosawvariousZZZZBestsignsandpermitsonthewalls."Itwasaverycleanjobsite,"hewroteforthefiles.ButGraywasnothingifnottenacious.WhenZZZZBestlaterclaimedtohavefinishedtheSanDiegojob,hedemandedtoseeitagain.Thiswasacrisis.Itwasonethingtowalksomepeoplethroughalittleemptyofficespace,butnowBarryandhisfriendswouldsomehowhavetogetcontrolofthesamebuildingandfinishitsinteriorintimetoshowtheplace.Itwouldcostafortune,butithadtobedone.Soafterdecliningtoleasethebuildingthefirsttimearound,Roddywassenttotrytomakeadealweekslater."Don'tgettooattachedtothatbeachhouse,"hetoldPadgettonthephone."Whatdoyoumean?""We'rehavingtroubledownhere.Thatbuildingisinreceivership.Theyjustwon'tleaseittous."Actually,themainproblemwasthatthebuilding'sprospectiveowner,BroeCo.ofDenver,foundthewholethingsosuspiciousitwantednopartofit.ThemoreRoddypleaded,themoreadamantlyBroeturnedhimdown.Thestakeswerehighernow,too.Bythespringof1987,ZZZZBesthadclimbedtomorethan$18pershare.DrexelBurnhamwasplanningtoraise$40millionforittobuythecompanythathadthecovetednationwideconcessiontocleancarpetsundertheSearsbanner.(Thedeallaterfellthrough.)WithGray'snewdemand,itseemed,thejigwasatlastup.Everyonewasfrantic.Theworldwasabouttoend.


BrianMorzesavedtheday.BrianisMark'solderbrother.Bothbrothersarephysicallypowerful,butwhereMarkishugeabovethewaist,Brianisgiganticatit.Heisfat,baldanddiabetic,withascragglyredbeardandpiercingeyessethalfwaybackintohishead.Heisalsosomethingofanintellectual,theonlypersoninvolvedwithZZZZBestwhocanusetheword"cognitive"inasentence.BrianarrivedfromPittsburghintimetohelphisbrothersolvetheSanDiegocrisis.Barryandhiscohortswerebickeringoverhowtoproceed.Roddyhadalreadyofferedtorenttheentirebuildingeitherforoneyearorjustseveralmonths,meetingtheaskingpriceanddoingallinteriorconstructionatorabovethelocalbuildingcode.Hispleaswereunavailing.ButBarrywouldnothearoffailure.FinallyBrianMorzeflewtoDenverandbasicallytoldtheBroepeople,"Okay,guys,youwin.Thetruthis,PadgettandRoddyworkforZZZZBest,andZZZZBestisthepartythatreallywantsthebuilding.Wewantedtokeepthewholethingsecretbecauseofsomeunusualactivityinourstocklately."Andsoon.Barryconfirmedallthis,andaleasewasnegotiated.ZZZZBesthadtotaketheplaceforsevenyears,putdown$500,000asasecuritydepositandpayamonth'srentinadvance.Ithurt,butLarryGray,inhisploddingbutinsistentway,hadmadeitunavoidable.Nowthattheyhadthebuilding,Barry'smenfacedanotherhurdle:gettingtheinteriorfinishedintimeforGray'sMay11visit.ZZZZBesttookpossessionaroundMay1,soithadjusttendaystowire,drywall,paint,carpetandotherwisecompletesixfloorsofofficespace(twowereareadydone).BecauseZZZZBestwasincapableofchangingalightbulbonitsown,muchlossrenovatinganentirebuildingovernight,ithadalreadypromisedabuildingcontractorunlimitedaccesstoabankaccountacrossthestreetfromtheworksite.Timewasoftheessence.Roddy,PadgettandBrianMorzesetupacommandpostatwhatwasthentheInterContinentalHotel,lookingoutacrossthewater,andimmediatelysentoutforsomegorgeous$200anhourcallgirls."Look,I'munderalotoftension,"Padgetttoldone."Let'sstartwiththemassageandgofromthere."Workingroundtheclock,theconstructioncrewsattackedtheunfinishedbuildingwithapassion.Everybodywasworried.Barryhadalreadybeenhospitalizedtwiceforulcersandexhaustionbutalsoexcited;theycouldn'tbelievethingshadcomethisfar.AtonepointBarryhimselfcamedowntoseehowtheworkwasgoing,touringthefacilitylikeChurchillvisitinghismenatthefront.Theplacewasamadhouse,butthereweresignsofprogress.Thinkingahead,RoddyhandedoutsomeZZZZBestTshirtsandgottheworkerstoposemomentarilyforpictures.OntheafternoonofMay10,lessthan24hoursbeforeLarryGraywasscheduledtovisit,thejobwasbasicallydone.Ithadcost$1million,butBarryalwaysunderstoodthatyouhavetospendmoneytostealmoney."ZZZZBestmagic,"Padgettcalledit,touringthebuildinginawe."Thisisamiracle."Thefollowingmorning,attheappointedhour,theMorzebrotherswalkedLarryGraythroughthebuilding."Joblooksverygood,"GrayIwrotelaterinamemotothefile,notnoticingthatsomeceilingsapparentlyweredroppedsolowthattheclosetdoorswouldn'topen."PerMorsetheyexpectfullacceptanceonthejoblaterthisweek."Thatsameday,GraywasflownouttoawarehouseinDallas,wherehelookedatabunchofcarpet---thesamestuffhe'dseeninSanDiegomonthsbefore.Whilehewasthere,MarkMorzestagedaphonecallthatsupposedlybroughtnewsof$10.1millioninnewjobsforZZZZBest.AsfortheactualworkinDallas,Graywrote,"Iwasinformedthatthecontractsareinhardhatstageandoutsidespectatorswerenotallowed."


Morzewastakingahugechancewiththis,becausenootherarrangementhadbeenmadeinDallas.Buttimewasshortanyway,andGray,whowasaccustomedtothingsbeinginorderatZZZZBest,saidthiswasfine.EverybodyflewbacktoLosAngeles.Barryandhisfriendshaddoneitagain.

end


MiniScribeCorporation

Thisisthestoryofacompanythatwasonthevergeofbankruptcy.MiniScribewasamoderatelysuccessfulcomputerdiskdrivemanufacturerinthecompetitivehightechenvironmentofcomputerparts.Thecompany'smaincustomerwasIBM.However,bymid1985,IBMdecidedtowithdrawitsbusinessfromMiniScribeandtomanufacturethediskdrivesinIBM'sownfactories.MiniScribebecameunprofitable.EntertheventurecapitalfirmofHambrecht&Quist.Itsawanopportunity.Withitsexperienceandreputationinthehightechcomputerindustry,thiscouldhavebeenaneasyrescue.Itschairman,Q.T.Wiles,alsoknownas"Mr.Fixit,"hadastringofturnaroundsuccesses.Thisrescuewasexpectedtobehiscrowningglorywithaninfusionof$20million.Heliveduptohisreputation.Mr.WileswasthearchitectandbuilderoftheplannedrebirthofMiniScribe.Hebeganbydemolishingthepriorstructureofmanagement:hefired20percentoftheemployeesandinstilledanewcorporatestructure.Whatwasamonolithicorganizationbecame20separatedivisions.Wileswieldedhisaxe,separatingthedivisions,eachwithitsownproducts,salesgoals,budgets,salesforces,andaccountability.MiniScribebegantoreportsoaringsalesandskyrocketingearnings.WallStreetfelloveritselftryingtograbthecoattailsofMiniScribe.Tomotivatemiddlemanagement,Wile'spersuasiontechniquescombinedfuryandfear.Accordingtopublishedequityreports,Wileswas"fairlyautocraticandverydemandingofthepeoplewhoworkforhim."AccordingtothereportsfromMiniScribeemployees,Wiles'managementstylewassadistic.HowelsedoyouexplainWiles'conductatameetingofmiddlemanagementinwhichhedemandedthattwocontrollersstand,andthen,infrontoftheirpeers,firedthemonthespot.Hethenproclaimedloudly:"That'sjusttoshoweveryoneI'mincontrolofthiscompany."TheWallStreetJournalreportedthataformercontrollerdescribedWiles'conductatmeetingswhereWileswouldthrow,kick,andripbudgetsthatdispleasedhim,flingingtheshredsofpaperathisintimidatedaudiencewhileyelling"Whydon'tyouunderstandthis?Whydon'tyouunderstandhowtodothis?"Q.T.Wilesparadedglowingfinancialstatementsthatshowedunprecedentedgrowth.BySeptember1988,theindustrywasinapublicizedslump;MiniScribe'sstockwentup,fivetimesitspricewhenWilestookovertwoyearsearlier.ThenthecompanydisintegratedwithabangthatstunnedWallStreet,filingforbankruptcyinJanuary1990.Wherethereanysigns?Pertinentquestionsthatshouldhavebeenaskedduring1988were:(1)Whyareaccountsreceivableatanalltimehighandgrowingmuchmorerapidlythansales?(2)Whyareinventoriesatanalltimehighandgrowingmuchmorerapidlythansales?InMayof1989,undertheweightofwhatturnedouttobeanunrelentingstringof falsefinancial,MiniScribe'sfacade crumbled. The company confessed that it did not know whether it could produce accurate financialstatementsforthepastthreeyears(inotherwords,sinceWilestookoverasCEO).

WhatDidManagementDo?Managersfranticallymonitoredtheirsalesgoals.Beforetheendofaquarter,theyknewtheamountofsalesneededtobeshippedinordertomeetMr.Wiles'quotas.Theythenreviewedtheircustomerliststodecidewhichcustomerscouldbeovershippedwithminimumrepercussions.Ononeoccasion,adivisionshippedacustomertwiceasmanydiskdrivesasthecustomerhadordered.


Whenthecustomerjustifiablycomplained,themanagerapologizedprofuselyandacceptedthereturn.However,thereturnwasreportedinthenextquarter.Theendresultwasthatthemanagermetthesalesquotaforthepreviousquarter,andsimplyhadthetaskofcompensatingforthisreturninthesucceedingquarter.Someploysfailed.Onemangerinhisefforttorecordanenormoussale,alteredthecustomaryFOBdesignationonashipment,enroutefromSingapore,foracustomerintheUnitedStates.Thecustomer'sordercontainedtheusualtermofsale:FOBitswarehouse.Themanager,accordingtothereports,alteredtheFOBdesignationfromthecustomer'swarehouseintheUnitedStatestoMiniScribe'sdockinSingapore.Hisintentwastorecordthesaleprematurely.Theauditorswerenotmisledbythechange,andtheployfailed.Companypersonnelresortedtoothermethodsofinflatingsales.OnesuchmethodwasthepracticeofshippingmerchandisetosmalllocalMiniScribewarehouseswhosepurposewastoservecustomerswithrapiddelivery.Theshipmentsweretreatedassales,wheninreality,theseshipmentsweretransfersofinventoryfromonecompanywarehousetoanother.Thecustomersdidnotgetpossessionoruseoftheinventory.ItwasreallyMiniScribe'sinventory.Onoccasionthecompanyshippedbricksratherthaninventory.Obviously,thisschemewasdoomedtofailure,sinceitkeptcompoundingitself,liketheEquityFundingpractices,whenthatcompanywrotefalseinsurancepolicies.Whenthepointofnoreturnwasreached,Wilesresigned.In1992,theauditorfirm,Coopers&Lybrandandtheinvestmentbank,Hambrecht&Quist,nowpartofJ.P.MorganChaseagreedpayshareholdersandcreditor$128million.[TheindependentauditorsofMiniscribewererepresentedbyHarveyPitt,wholaterbecamechairmanoftheSEC].

end


SunbeamDangerousGames

Did“ChainsawAl”DunlapmanufactureSunbeam'searnings?Albert Dunlap likes to tell how confidants warned him in 1996 that taking the top job at the small-appliancemaker SunbeamCorpwould likely be his Vietnam. For a time, the 60-year-oldWest Point graduate seeminglyprovedtheCassandraswrong.

Astheposterboyof‘Nineties-stylecorporatecost-cutting,hedeliveredexactlythehugebodycountsandpunishingairstrikesthatWallStreetloved.HedumpedhalfofSunbeam's12,000employeesbyeitherlayingthemofforsellingtheoperationswheretheyworked.Inall,heshutteredorsoldabout80ofSunbeam's114plants,officesandwarehouses.

Sunbeam'ssalesandearningsresponded,andsodiditsstockprice,risingfrom$12.50asharethedayDunlap

tookoverinJuly1996toahighof$53inMarch1998.Immediatelyafterthestockpeakedatapriceof$53Sunbeamsufferedareversaloffortune.Afterseveralmildwarningsofapossiblerevenuedisappointment,SunbeamshockedWallStreetbyreportingalossof$44.6millionforthefirstquarteronasalesdeclineof3.6%.TheSunbeamcost-cuttingstorywasdead,alongwith“ChainsawAl”Dunlap’simageasthesuprememaximizerofshareholdervalue.Dunlap'slasthurrahasacorporateturnaroundartist,hasturnedintoagrindingmarathon.LyingintattersishisgrowthscenarioforSunbeam,basedonsupposedlysexynewofferingssuchassoft-icecreammakers,fancygrills,homewaterpurifiersandair-filterappliances.Manyofthenewproductshavebombedinthemarketplaceorrunintoseriousqualityproblems.Moreover,Sunbeamhasrunintoallmannerofproduction,qualityanddeliveryproblems.ItrecentlyannouncedtheclosingoftwoMexicanmanufacturingfacilitieswithsome2,800workers,citingthefacilities'lamentableperformance.Dozensofkeyexecutives,membersofwhatDunlapjustmonthsagocalledhisDreamTeam,arebailingout.Andnowhefacesanotheryearormoreofthewrenchingrestructuringthat’sneededtomeldSunbeamwithitsrecentlyannouncedacquisitions,includingthecamping-equipmentmakerColemanCo.,thesmoke-detectorproducerFirstAlertandSignatureBrandsUSA,bestknownforitsMr.Coffeelineofappliances.Theseacquisitionswilldoublethesizeofacompanywhosewheelsarecomingoff.

Sunbeamdeclinedtodiscussthecompany’sproblemswiththepress.WallStreetisstillbuzzingovera

confrontationthatDunlaphadwithPaineWebberanalystAndrewShoreataSunbeammeetingwiththefinancialcommunityinNewYorkinearly1998.ShorehadthetemeritytoaskseveralquestionsthatDunlapdeemedimpertinent,andDunlapsnarled,"Yousonofabitch.Ifyouwanttocomeafterme,I'llcomeafteryoutwiceashard."

Shore,thefirstmajoranalysttodowngradeSunbeam'sstockinApril1998whenwordbegantocirculateofa

possiblefirstquarterearningsdebacle,isstillupsetovertheincident."AsfarasI'mconcerned,AlisthemostoverratedCEOinAmerica,"hegrouses.“He'snothingbutabullywhospeaksinsoundbitesandcompletelylackssubstance”.

DespiteSunbeam'slatestreversaloffortune,don'texpectAlDunlaptobeheadedforthepoorhouseanytime

soon.ThoughtheswooninSunbeamshareshasvaporizedthevalueoftheoptionsheldbymostofthecompany'sexecutivesandmanagers,Dunlap'shugeoptionandstockgrantsarestillworthabout$70million,downfromapeakvalueofover$300millionwhenthestockwasatitshigh.Moreover,inFebruary1998Dunlapnegotiatedanewcontract,doublinghisannualbasesalaryto$2million.Underarichbenefitspackage,SunbeamevenfootsthebillforDunlapandhiswife'sfirst-classairfarefromFlorida,whereSunbeamisheadquartered,toPhiladelphiasothatDunlapcanvisithispersonaldentisttokeephislatestbridgecomfyandpearlywhite.LimochargesandovernightsattheFourSeasonshotelareincludedaswell.Allthisfromtheself-styledchampionofshareholdervalue.

NotallweresurprisedbySunbeam'scurrentwoes.Inacoverstoryin1997,Barron’scastaskepticaleyeat

Dunlap'sgrowthobjectivesinthelow-margin,cutthroatsmall-applianceindustry.Theypointedouttheyawning


gapbetweenSunbeam'sperformanceclaim'sandreality.TheytookspecialnoteofSunbeam'saccountinggimmickry,whichappearedtohavetransmogrifiedthroughaccountingwizardrythecompany'smonster1996restructuringcharge($337millionbeforetaxes)into1997’seye-poppingsalesandearningsrebound.Buttonoavail.WallStreetremainedimpressedbySunbeam'searnings,andthestockcontinuedtorise.

Sunbeam'sfinancialsunderDunlaplooklikeanexerciseinhigh-energyphysics,inwhichtimeandspaceseem

tofuseandbend.Theyareaveritablecloudchamber.Incomeandcostsmovealmostimperceptiblybackandforthbetweentheincomestatementandbalancesheetlikechargedions,whosevaportrailhaslongsincedissipatedbytheendofanyquarter,whenresultsarereported.Therearealsosomesignsofotheraccountingshenanigansandpuffery,includingsalesandrelatedprofitsbookedinperiodsbeforethegoodswereactuallyshipped.Bookingsalesandearningsinadvancecancomplywithaccountingregulationsundercertainstrictcircumstances.

“Wehadanamazingyear,”DunlapcrowedinSunbeam'sthe1997annualreport,takinganimpromptuvictory

lapfortheprofitof$109.4million,$1.41ashare,onsalesof$1.2billion.[TheP/Ereached50].Sunbeamhadeveryincentivetotrytoshootthelightsoutin1997.DunlapandcrewwereconvincedtheywouldbeabletoattractabuyerforthecompanyjustastheyhaddoneinthesecondyearoftheirrestructuringofScottPaperin1995,whenDunlapmanagedtofobScottoffonKimberly-Clarkfor$9billion.

TheyopenlyshoppedSunbeamaround,buttheoffernevercame.Therisingstockpricemadethecompanytoo

expensive,andwould-bebuyerswerealsodeterredbythenightmaresKimberly-ClarkexperiencedafterbuyingScott.

Yet,sadtosay,theearningsfromSunbeam'ssupposedbreakthroughyearappeartobelargelymanufactured.

Startwiththefactthatinthe1996restructuring,Sunbeamchosetowritedowntozerosome$90millionofitsinventoryforproductlinesbeingdiscontinuedandotherperfectlygooditems.EvenifSunbeamrealizedjust50centsonthedollarbysellingthesegoodsin1997(insomecases,theyreportedlydidevenbetter),thatwouldaccountforaboutathirdoflastyear'snetincomeof$109.4million.

Onehastogotothe1997year-endbalancesheettodetectmoreofmother'slittlehelpers.WhydidSunbeam's

"OtherCurrentLiabilities”mysteriouslydropby$18.1millionand"OtherLong-TermLiabilities"fallby$19millionin1997?Theanswerissimple,accordingtofolksclosetothecompany.VariousreservesforproductwarrantiesandotheritemsthatweresetasideduringSunbeam'sgiant1996restructuringweredraineddownin1997,creatingperhapsanadditional$25millionorsoinadditionalnetincomefortheyear.

Ontopofallthat,aspartofthe1996re-structuringcharge,Sunbeamreducedthevalueofitsproperty,plant,

equipmentandtrademarksby$92million.ThoughsomeofthesechargesappliedtoassetsSunbeamwassellingoff,thebulkofthechargerelatedtoongoingoperations.ThisallowedSunbeamtoloweritsdepreciationandamortizationexpenseonthe1997incomestatementbynearly$9million.Thatwouldcreateabout$6millionofadditionalafter-taxincome.

Oddlyenough,thefigurefornetproperty,plantandequipmentonSunbeam'sbalancesheetstillroseduring

1997,to$241millionfrom$220milliontheyearbefore.Thisislikelyanindicationthatsuchcostsasproductdevelopment,newpackagingandsomeadvertisingandmarketinginitiativeswerecapitalizedorputstraightonthebalancesheetinsteadofbeingexpensedintheyeartheywereincurred,aswasthepreviouspractice.Inthismanner,expensescouldhavebeenshiftedfrom1997intofutureyears,whentheycanbeburnedoffataslower,moredecorouspaceaffordedbymulti-yeardepreciationschedules.WhyelsewouldSunbeam'sadvertisingandpromotionexpensedropbysome$15million,from$71.5millionin1996to$56.4millionlastyear?ParticularlywhenSunbeamtrottedoutasplashynationaltelevisionadcampaignin1997toboostconsumerdemandforitsnewproducts.Thisadvertisingshortfallalonecontributedanother$10milliontoSunbeam's1997profits.[ThisissimilartotheaccountingthatL.A.Geardidin1989-1990].Thecompanyalsogotaniceboostfroma64%dropinitsallowancefordoubtfulaccountsandcashdiscounts,from$23.4millionin1996to$8.4millionin1997.Andthisdeclineoccurreddespitea19%riseinSunbeam'ssaleslastyear.Themilkingofthisbaddebtreservein1997likelypuffednetincomebyanadditional$10millionorso.

Thenthere'sthemysteryofwhySunbeam'sinventoriesexplodedbysome40%,or$93million,during1997.

Quitepossibly,Sunbeamwasplayinggameswithitsinventoriestohelptheincomestatement.Byrunningplants


flatoutandbuildinginventories,acompanycanshiftfixedoverheadcostsfromtheincomestatementtothebal-ancesheetwheretheyremainensconcedaspartofthevalueoftheinventoryuntilsuchtimeastheinventoryissold.Tobeconservative,let'sassumethisinventorybuildupmighthavehelpedSunbeam'sprofitstothetuneof,say,$10million.

Lastly,therearemorethansuperficialindicationsthatSunbeamjammedasmanysalesasitcouldinto1997to

pumpboththetopandbottomlines.Therevenuegamesbeganinnocentlyenoughearlylastyear.Saleswereapparentlydelayedinlate1996,alostyearanyway,andrammedinto1997.Likewise,TheWallStreetJournalreportedseveralinstancesof"inventorystuffing"during1997,inwhichSunbeameithersentmoregoodsthanhadbeenorderedbycustomersorshippedgoodsevenafteranorderhadbeencancelled.Butthesearecomparativelyvenialsinsthatcompaniesengageinallthetimetomakeaquarter'sresultslookbetter.Besides,Sunbeamgavetheplausibleexcuseatthetimethatglitchesinacomputersystemconsolidationinthefirstquarterhadthemflyingblindforatime.

Butas1997draggedonandthepressuretoperformforWallStreetintensified,Sunbeambegantotakegreater

andgreaterlibertieswithsalestermstopuffcurrentresults.Inthefourthquarterof1997,Sunbeamrecordedsome$50millioninsalesofcookinggrillsunderan"earlybuy"programthatallowedretailerstodelaypaymentfortheitemsaslongassixmonths.Moreover,some$35millionofthese“earlybuys”werecategorized“billandhold”salesandneverevenleftSunbeam'swarehouses.

Sunbeamengagedinbill-and-holdtransactionsinotherproductlines,too,accordingtoanumberofpeoplein

theapplianceindustry.Inthesecondquarter,forexample,Sunbeambookedasaleand“shipped”some$10millionofblanketstoawarehouseithadrentedinMississippinearitsHattiesburgdistributioncenter.TheywereheldthereforsomeweeksforWal-Mart.Thecompanyalsopumpedmillionsofdollarsofgoodsintoseveralna-tionalsmall-appliancedistributorsonsucheasypaymenttermsastocallintoquestionwhetherasaleevertookplace.SomewithknowledgeofSunbeam'sbusinesspracticessaytheappliancemakerinsomeinstancestransferredtitleforthegoodstodistributorsbutthenagreedtonotonlydelaypaymentbutactuallypaythedistributorswhatamountedtoastoragechargefortakingthegoods.ThesesourcesalsosaidthatinsomecasesdistributorsalsohadtherighttoreturntheitemstoSunbeamwithoutsufferinganyloss.

Howmuchdidvarioustypesofquestionablesalesaddto1997'snetincome?Nooutsidercanknowforsure.

ButwecanmakeaneducatedguessbasedonthefactthatSunbeam'sreceivables,orunpaidcustomeraccounts,jumpedby38%,or$82million, in1997.TakingintoaccountSunSunbeam'sprofitmargins, itseemsthatques-tionablesalescouldhaveboosted1997netincomebyasmuchas$8million.

WebynomeansareprivytoallSunbeam'stechniquesforharvestingcurrentearningsfrompastrestructuring

chargesandfuturesales.DeconstructingAlDunlapisadauntingtask.Buttosaveourgentlereaderstheeffort,ourtotalestimateofartificialprofitboostersin1997cametoaround$120millioncomparedwiththe$109.4millionprofitthecompanyactuallyreported.Thus,oneislefttowonderwhetherSunbeammodeanythingatallfromitsactualoperations,despiteDunlap'sclaimtohaverealizedsome$225millionincostsavingsasaresultofhisrestructuringprowess.

OurdourviewofSunbeam'scurrentfinancialhealthisonlyconfirmedbythecompany'sconsolidated

statementofcashflowinthelatest10-K.Thesenumbers,ofcourse,arehardertofinessebecausetheytracktheactualcashthatflowedinandoutofthecompanyduring1997.Andthestatementdoesn'tpaintaprettypicture.Despite1997'seye-catching$109.4millionnetprofit,Sunbeamstillsufferednegativecashflowfromoperationsof$8.2million,altertakingintoaccounttheexplosioninSunbeam'sinventoryandaccountsreceivableduringtheyear.Andthatoperatingcashflowdeficitwouldhavebeenanevenlarger$67.2millionifnotforthesaleof$59millioninreceivablesinthelastweekof1997.Aftercapitalexpendituresof$58.3millionisthrownintotheequation,Sunbeam'sfreecashflowdeficitamountstomorethan$125million.

Sunbeam'sfirst-quarter1998earningsdebaclewasyetanothersignofacompanythat'sinanythingbutthe

pinkofhealth.DespitemanagementassertionsintoAprilthatSunbeam'sfirst-quartersaleswouldfinishcomfortablyaheadofthoseforthefirstquarterof1997,theyendedupdeclining4%.EvenmoreshockingtoDunlap'sfanswasthe$44.6millionlossintheMarchquartercomparedwithaprofitintheyear-earlierperiodof$6.9million.Sure,$36.8millionofthatfirst-quarterlosswastheresultofnonrecurringcharges,mostlya


handsomenewpaypackageDunlapmanagedtonegotiateinFebruary.ButtheoperatinglossSunbeamsufferedof$7.8millionwasaclearsignofitstrueearningspoweroncethetankfromthe1996restructuringchargehadrundry.

Dunlaptrottedoutawholeraftofexcusesforthecompany'slamentablefirst-quarterperformance.Hecited

dumbdealshisformerNo.3executivehadmadewithmajorretailersbeforeChainsawfiredhiminApril,theeffectofbadweatherongrillsalescausedbyElNino,andsoforth.

Whateverthecase,thefirst-quarterdisasterwasn'ttheresultofanylackofeffortonSunbeam'sparttopump

uptheresults.Thecompanyrecorded$29millionofadditional“buynow,paylater”grillsales.Infact,thecompanyisnowholdingsomanygrillsinvariouswarehousesarounditsNeosho,Missouri,grillplantthatithashadtoleasewarehousespaceinnearbyOklahoma.Whoknowshowmanyofthesegrillswillevermakeittothesellingfloor?

Sunbeamalsoextendeditsquarterbythreedays,fromMarch28toMarch31.Thisallowedthecompanyto

bookanextra$20millioninsalesbothfromongoingSunbeamoperationsandtwodaysofsalesfromColeman(itsacquisitionclosedonMarch30).Buttonoavail.Sunbeamstillfell$9millionshortoflastyear'ssalesof$253.5million.

ReportsarerifethatSunbeamtriedtostrong-armsuppliersinto“recutting”theirinvoicesforvariousgoods

andservicessothatSunbeamwouldofficiallyowelessmoney.Theprovisowasthatthesupplierswouldbeallowedtoaddbacktheamountforgone,plusinterest,ininvoicessubmittedafterthefirstquarterhadended.ASunbeamfinancialofficialdeniesthe“recutting”chargeandcharacterizestheactivitybythecompany'sprocurementdepartmentasthenormalgiveandtakethatgoesonbetweensuppliersandcompaniesseekingrebates.

Butthat'snottheunderstandingheldbyanofficialatoneChina-basedsupplier.WhencontactedbyBarron’s,

thisofficialreadilyacknowledgedthathehadsentSunbeamacheckfor$500,000,or5%ofthebusinesshedoesannuallywiththecompany,inlateMarch.“TheonlyreasonIsentthemacheckratherthananewinvoiceisthatwehadnoinvoicesoutstandingatthetimewereceivedthecall,”heexplained.“WefigureourcontributiondroppedrightdowntothebottomlineifSunbeamactuallybookedit.Idon'tknowwhathappened,though.”

Forthenextfewquarters,expecttherecentacquisitionofColeman,FirstAlertandMr.Coffeetorestorea

measureofcalmtoSunbeam'sfinancialperformance.ThegiantrestructuringchargesthatSunbeamistakingtointegratethenewunits,at$390millionbeforetaxes,willgivethecompanyplentyoffodderwithwhichtoplayearningsgames.Thecompanyisevenforecastingearningsof$1asharethisyearand$2nextyear--beforeextraordinaryitems,naturally.


ButDunlap'sdaysatSunbeammaybenumbered.Thealready-ailingcompanynowhas tostruggleunder$2

billionof additionaldebt.Andhis enemies, includingdisenchanted shareholders, angry securities analysts, andbitterformeremployees,aregrowinginnumberandcirclingeverclosertothecompany'shead-quartersinDelrayBeach.Ofcourse,Dunlapcouldalwaysescapebyusingthebuilding'sflatrooftochopperout,shoulditcometothat.Onecanonlyhopehe'llremembertotaketheAmericanflagwithhim.

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[[OnJune13,1998theoutsidedirectorsfiredDunlap.]]

Oneofthemostcreativemethodsofproducingprofitswasaspare-partsgambit.Sunbeamownedlotsofspareparts,usedtofixblendersandgrillswhentheybroke.ThosepartswerestoredinthewarehouseofacompanycalledEPIPrinters,whichsentthepartsoutwhenneeded.Herewasthebrilliantstrategy.Sell$3millionofinventorytoEPIfor$11millionandbookan$8millionprofit.ButEPIknewthesparepartswereworthonly$2million.Sunbeamfoundawayaroundtheproblem.EPIwaspersuadedtosignan"agreementtoagree"tobutthepartsfor$11millionwithaclauseallowingEPItowalkawayinJanuary1998,justafteryearend.AlongcamePhilipE.Harlow,theArthurAndersenpartnerinchargeoftheSunbeamaudit.HeconcludedtheprofitwasnotallowedunderGAAPsoSunbeamcuttheprofitto$5millionbutwouldgonofurther.HarlowdecidedthattheprofitwasNOTMATERIAL.Similarly,theSEChasdeterminedheallowedtheinclusionofotheritemshehadchallengedthattotaled16%oftheprofitfortheyear.ArthurAndersensaysthiscasedoesnotinvolvefraud,but"professionaldisagreementsabouttheapplicationofsophisticatedaccountingstandards."

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INCOME STATEMENT ISSUES Revenue Recognition

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