Suspicion! Is Your CEO Holding Out on You?
from
September/October 2002
by Bonnie Azab Powell
You know the feeling. Something is off.
Maybe the CEO of the company whose board you're on has stopped
communicating as frequently as he once did, or maybe he's sticking to
the big picture when he used to pore over every fundamental. Perhaps
the second CFO in as many months has quit, trailing a blimp-sized
golden parachute, with "Not her fault, it just wasn't a good fit" as
the CEO's only explanation. Or maybe the audit committee has raised
questions about a mysterious, unexplained increase that appears one
month in accounts receivables, only to show up later in inventory.
Perhaps worst of all—because of the shareholder lawsuits any
restatement of earnings is sure to inspire—an anonymous letter alleges
that the company is overstating revenues.
Any number of scenarios can cause a board to lose faith in its CEO, and nowadays directors cannot afford to deflect such doubts. The roll call of recently deposed executives suggests that a number of boards were bamboozled or just plain let down by CEOs who dropped the ball. Among the departed (see the box on page 36): Charles Conaway, from Kmart Corp.; Bernie Ebbers, from WorldCom; Steve Gardner, from Peregrine Systems; Michael P. Haydock, from Cray Inc.; Dennis Kozlowski, from Tyco International; William Larson, from Network Associates; and John Rigas, from Adelphia Communications. And let's not forget the co-stars of that debacle in Texas, whose financial chicanery seems to have earned them a permanent slot on the front page of The Wall Street Journal: former Enron CEO Kenneth Lay and Joseph F. Berardino, formerly of Arthur Andersen.
Back in April, in response to public concerns over governance raised by Enron's collapse, the National Association of Corporate Directors (NACD) gave Congress a list of 10 general standards that it recommends directors of public companies adopt. No. 5 on the list: "Boards should regularly and formally evaluate the performance of the CEO, other senior managers, the board as a whole, and individual directors. Independent directors should control the methods and criteria for this evaluation."
Many boards already issue such report cards, and your job is always easier if the evaluation uncovers a CEO who's lost his touch rather than one who's dishonest. The realization that he's been dropping the ball could also explain why he may have turned silent. Before calling in the turnaround crew, ask him about the communication lapse and then raise the issue of why the company is faltering.
"As a board member, I once had a situation where a manufacturing company had been progressing very well, but suddenly it began losing market share," recalls Hal Shear, chairman of the Silicon Valley chapter of the NACD and CEO of the financial firm Research Investment Advisors Ltd. "The CEO refused to acknowledge that there was a problem. He wanted to rely on an existing sales channel that was not producing. We worked with him for six months to try and reconcile his views with our feeling that it was time to revisit the whole sales strategy. In the end, we were forced to replace him."
When you have that uneasy sense that the company is floundering, the safest way to discharge your responsibilities as a director—to investors, creditors, and others—is to call in a turnaround firm for advice. These specialists will perform an operational assessment of the company, identifying strengths and weaknesses, and will recommend a course of action for the board. If the consensus is that the CEO can't handle the new demands, these firms can usually supply a clear-eyed, hard-nosed temp. "When times are going smoothly and sales are up 3%, that takes a certain personality. But when you're losing 20% a year market share, it takes a different mind-set," says Miles Stover, a principal with the turnaround management consulting firm Crossroads, based in Irvine, California. "Many times we're asked to come in just because the CEO doesn't have the right skill set for that time in the company's history."
Once you've brought in turnaround experts, take a deep breath and let them do their jobs. "This is combat, and we're Green Berets," says Steven Gerbsman, the tough-talking head of Gerbsman Partners, a turnaround outfit in Kentfield, California. "We'll go in and make 10 decisions immediately. We're not held to the problems of the past. Our mission is to preserve, control, and forecast cash at all costs."
But what if your doubts are not about the CEO's competence but about his integrity? As the Enron debacle shows, directors shouldn't count on the auditors. In its 2002 Report to the Nation, the Association of Certified Fraud Examiners pointed to 663 cases of occupational fraud—loosely, cases where someone takes advantage of his job to steal—that last year cost U.S. businesses more than $7 billion.
How did the crimes come to light? According to the study, a mere 18.6% were uncovered in the course of internal audits. Slightly more (18.8%) were stumbled across by accident. And 26.3% were uncovered after anonymous tips from employees. Crossroads' Miles Stover values Deep Throats most of all. "More than 50% of the cases in which we discover big fraud come through an anonymous tip," he says.
"Rarely is a situation discovered by the board reading annual reports and noticing certain ratios are off," adds James B. Hunt, a principal in the forensics-accounting group at PM Keypoint, a Los Angeles-based consulting organization that specializes in expert-witness work for antitrust, intellectual-property, and commercial damages. "There's not a lot that directors can do in terms of vigilance without having the appearance of snooping and encroaching on their CEO. What is important is that they don't disregard informants."
By far the most common type of financial wrongdoing is what Hunt calls "five-fingered," by which he means asset misappropriation and corruption. The methods by which crooked CEOs line their own pockets include arranging fraudulent disbursements (billing, payroll, and expense-reimbursement schemes among them), skimming revenues, stealing inventory, accepting kickbacks from customers or suppliers, and engaging in conflicts of interest.
Jonathan Vanderveen—a CPA, forensic accountant, and former auditor who is now a partner in Deloitte & Touche's corporate-investigations practice in Chicago—has seen his share of scams. In one of the many cases he's investigated, a publicly held construction company bought a smaller firm but left the former owner in place as president. This was an expensive mistake. The man continued to run the company as if he still owned it, disregarding the new owners, his own fiduciary duties, and a truckload of Securities and Exchange Commission requirements. The board soon began to wonder whether he was honest, and this suspicion was heightened by an anonymous tip to the company alleging that the man was up to all kinds of mischief, such as pocketing various revenues instead of booking them. Not knowing how best to confront him themselves, and fearful of his reputation for volatile behavior, the directors called Deloitte & Touche for advice.
"I recommended that the board seek independent counsel," says Vanderveen. He then suggested that the man be placed on paid administrative leave for the duration of the investigation. "With the advice of counsel, the board can make that call. That way we take the person out of his influential role regarding decision-making and financial reporting, so he can't influence the people we want to interview or the business decisions that need to be made that day or the next."
Armed security officers first escorted the executive from the premises and then led Vanderveen and his team in. The evidence was all there: The president had indeed been operating a business on the side, not only keeping whatever customers paid but charging the company for the labor and materials he used in his off-the-books construction jobs.
Crossroads' Miles Stover, who is also a certified fraud examiner, says that operational inefficiencies are often clues to the existence of fraud. What he calls "a well-known California venture capital firm"—for obvious reasons, most investigators won't disclose clients' names—grew suspicious of a Mexico-based outdoor-furniture company it had invested in. "Direct labor costs were going way up, but production wasn't," says Stover. From their calculations 2,000 miles away, there appeared to be some 800 employees.
Stover went to Mexico and checked out the factory's first shift, finding about 175 workers. When the supervisor volunteered that there were never more than two shifts, Stover concluded that the general manager was probably putting the phantom portion of the payroll into his own pocket. The result? "We came in, terminated the top management team, and assumed the operational management of the company," he says.
Five-fingered fraud may be the most common variety, but it isn't what boards should fear most. The average asset misappropriation costs $80,000. In contrast, falsifying a company's financial statements racks up an average cost of $4.25 million just to investigate and redo the accounts and paperwork. The next cost—shareholder lawsuits—can run way over that. "If you're making material misstatements that affect the earnings per share, and that runs through a market multiple that affects the stock price, and if the stock price is higher than it ought to be, tens of millions of market capital are at risk," says James Hunt, who has a 30-year-plus career in public accounting and forensic investigations. He joined PM Keypoint in April after 20 years with PricewaterhouseCoopers's investigation practice.
In one of his cases, the controller at a health-care company informed the board of directors that on two occasions, just before closing the quarterly books, the CEO had tried to persuade her to make the numbers look better than they were. Specifically, he wanted her to round up various numbers to the nearest thousand and to "book up," or increase revenues and receivables, to account for Medicare reimbursements and other cash he was "sure" was just tied up in the system. With the company in the middle of a road show for a securities offering, the controller's allegations could not have come at a more sensitive time.
The in-house legal team investigated, interviewing the controller and others, and reassured the board that it was all a big misunderstanding. "It was very unfortunate, in that we later learned that the informants had told them the real story, but it never got to the board," says Hunt.
The controller then went to her counterpart on the outside audit team, part of a Big Five accounting firm. This time the allegations found friendlier ears. The outside auditors issued an ultimatum: Either the company would perform an exhaustive, unbiased investigation of the charges, or the firm would resign from the account. As a result, the board hired independent outside legal counsel and forensic accountants to reinvestigate the charges. Among the pieces of evidence that turned up: various e-mails on archived computer tapes that showed the CEO's eagerness to pad revenues.
The board demanded the CEO's resignation, but the event also cost the controller her job. She was sanctioned by the SEC, and that got her fired. Was this fair? Absolutely, says Hunt. "The SEC doesn't differentiate," he says. "It expects professional accountants to be like the goalie on the soccer field, the last thing between the scorers and the goal."
The moral of these stories? When a board has doubts, it should hire the best unbiased counsel it can find. "Instead of going to the outside law firm that you regularly use, consider using a law firm that is independent and that has the qualifications to run the investigation," advises Vanderveen. This is not the time to use in-house counsel.
In addition to their independence, investigators like those at Deloitte & Touche, Crossroads, and PM Keypoint have many tools at their disposal. They can go to computer hard drives and servers, uncovering evidence that no amount of interviews or midnight hours spent poring over the books will provide. They also have access to other professionals who can offer services more commonly found in crime novels. "In one case, Deloitte recommended that the company put an employee under surveillance," recalls Vanderveen. "The PI came back and told us he had good news and bad news: 'The bad news is, I tailed the wrong guy. The good news is, I found out your purchasing manager is a drug dealer.'"
Hunt says that all boards should have a closed-door session with senior members of the independent accounting firm and should press for information that may point to anything odd. Perhaps the company has increasingly come to rely on a single vendor—and you happen to know that the CEO's family has just returned from a trip to Disney World with the vendor's kids. To that Shear adds, "Ask the really hard questions. What the Enron board has said over and over again is that they just didn't understand. And that's just not acceptable."
In terms of prevention, the easiest and most effective strategy is to install a fraud hotline. Not only does this give employees a safe, anonymous way to report wrongdoing, but it sends a clear message to the CEO—and anyone else who's tempted to stray—that the company is not an anything-goes fiefdom.
