only for those not on heart medicine, from the wsj - August 13, 1998
How Two Whistle-Blowers Sparked
Fraud Probe That Crushed Cendant
By EMILY NELSON and JOANN S. LUBLIN
Staff Reporters of THE WALL STREET JOURNAL
"Are you sitting down?"
The question came from Michael P. Monaco, Cendant Corp.'s chief financial officer, in an April 9 call to Cendant Chief Executive Henry R. Silverman. In December, Cendant had been created by the $14 billion merger of HFS Inc., run by Mr. Silverman, and CUC International Inc. Now, Mr. Monaco told his boss, "we have a problem."
Cendant's Stock Price Drop Could Change Terms of Deal
At a meeting at Cendant's Parsippany, N.J., headquarters, two former CUC managers who stayed on after the merger, Casper Sabatino and Steven Speaks, had just alleged to Mr. Monaco a breathtaking fraud. In many past quarters, they said, they had been instructed by CUC superiors to inflate revenue through bogus accounting.
In sworn affidavits taken by Cendant investigators days later, they spelled it all out. They said they had been told to record millions of dollars of phony orders. Mr. Sabatino said he had been told to arbitrarily adjust revenue up or expenses down. He had raided reserves set up for merger costs to cover revenue shortfalls. In short, the men alleged that they had cooked the books to order for CUC executives, and specifically named Anne Pember, CUC's former senior vice president of finance and controller; one of the affidavits also named Cosmo Corigliano, formerly CUC's chief financial officer.
Mr. Sabatino and Mr. Speaks decline to comment. Mr. Corigliano, who was fired from Cendant days after the meeting, denies any wrongdoing. Through her lawyer, Ms. Pember, who left Cendant in March, declined to comment, except to say that allegations concerning Ms. Pember are inaccurate.
The whistle-blowing of Mr. Sabatino and Mr. Speaks has echoed loudly. Late on April 15, one day after the two men signed their affidavits, Cendant revealed that it had uncovered extensive alleged accounting irregularities at the former CUC. The next day, Cendant stock plunged 46.5%, blasting about $14 billion off Cendant's market capitalization.
Since then, Cendant says it has uncovered evidence of far more wide-ranging fraud. It now estimates, based on internal investigations by accounting firm Arthur Andersen and others, that about $500 million of revenue reported by CUC from 1995 to 1997 was simply invented. It says that 61% of CUC's 1997 net income was fake. Cendant has lost about $20 billion of market value since mid-April.
Walter Forbes, CUC's founder and former chief executive and Cendant's chairman, has resigned, though he says he knew of no accounting problems. Under the merger terms, he was to swap jobs with Mr. Silverman on Jan. 1, 2000, and become Cendant's CEO. Investors have filed at least 71 lawsuits. The U.S. Attorney's office in Newark, N.J., and the U.S. Securities and Exchange Commission are investigating. Others are trying to sort out how an alliance involving Mr. Silverman, a celebrated deal maker, and Mr. Forbes, a vaunted entrepreneur, could wind up such a fiasco.
Some answers are now beginning to take shape. In dozens of interviews with past and present executives and directors, the Cendant saga emerges as a tale of missed -- or ignored -- warning signs and deep mistrust in a corporate marriage that seems to have had as much to do with the desire to keep stock prices climbing in a growth-happy market as with fundamental business sense.
As for the alleged fraud, Cendant investigators say it appears to have been simple. People just made things up.
At first glance, the companies hardly seemed compatible. Through acquisitions, Mr. Silverman had built HFS into a franchising powerhouse with brands like Ramada and Howard Johnson in lodging, Coldwell Banker in real estate and Avis in rental cars. CUC, based in Stamford, Conn., was a hodgepodge of businesses, including software, advertising publications and an on-line venture.
But like HFS, CUC offered services and collected fees, with its main revenue coming from memberships in discount shopping, travel and entertainment clubs. Both relied heavily on customer lists to sell other services. Mr. Forbes, in an interview last December, noted that he and Mr. Silverman were "exact clones."
Actually, the two executives had little in common. Mr. Forbes, 55 years old, is a former journalism major and Harvard Business School graduate who sees himself as a visionary and leaves details to others. Sidney R. Bowen III, a former headhunter for CUC, recalls meetings in Mr. Forbes's office in which Mr. Forbes would sit "with no shoes, often no socks, eating saltines and thinking about his next idea."
Mr. Silverman, a 58-year-old former tax lawyer, demands detailed monthly financial reports and daily cash-flow figures. Sharp-tongued and aggressive, the nattily dressed CEO brings subsidiary heads to New York each month to report on their businesses.
The two started talking about a deal early last year. Mr. Silverman says his CUC due diligence was thorough, but based almost entirely on public information audited by Ernst & Young, CUC's auditor. CUC refused to share certain nonpublic data, arguing that if the deal fell through, HFS would use it to compete head-on with CUC, possibly by acquiring a rival. "We did what public companies do whenever they're merging with another public company," Mr. Silverman says now.
But CUC has had accounting problems before. In 1989, it was criticized by investors for spreading out the cost of recruiting new members over three years instead of reflecting those costs right away. It changed its accounting methods and took a charge.
In 1991, the SEC questioned the completeness of CUC's financial documents and required numerous amendments to them.
None of the earlier accounting questions had raised Mr. Silverman's suspicions. Nor did Mr. Forbes's insistence that CUC accounting initially remain separate from HFS's. That's rare in a merger, and might have set off alarm bells, particularly for a veteran deal maker and numbers man like Mr. Silverman. But it didn't. To cut costs, Mr. Silverman also wanted to eliminate part of CUC's internal accounting department, which included Ms. Pember. Mr. Forbes made a spirited argument against the plan, saying it would hurt morale. Mr. Silverman thought Mr. Forbes's position strange, but relented.
Cendant's Bogus Revenue Neared $300 Million Over 3-Year Period (July 15)
Cendant Dismisses a Senior Executive As More Details of Problems Emerge (April 20)
Cendant Stock Plunges 46.5% on News That Accounting Woes Hurt Earnings (April 17)
Other issues were festering. Mr. Forbes's chief operating officer, E. Kirk Shelton, was to sell a CUC unit to resolve regulatory concerns. Mr. Silverman stewed when the sale took so long that the Cendant merger didn't close until December, months behind schedule.
Mr. Forbes was beginning to have questions about Mr. Silverman, too. When the men agreed to the merger, they decided over dinner that Mr. Forbes would be chairman, Mr. Silverman would be chief executive and the two -- as well some top lieutenants -- would switch jobs in 2000. In late November, though, Mr. Silverman faxed Mr. Forbes a letter to his home proposing that they delay the swaps six more months, since the merger had been delayed. Mr. Forbes refused.
After the merger closed, Mr. Silverman moved to bring CUC into the fold. At Cendant's January meeting for its 40-plus senior managers at New York's Waldorf-Astoria Hotel, Mr. Silverman privately asked Mr. Corigliano, the former CUC chief financial officer and then a Cendant executive vice president, and Mr. Shelton, who after the merger became a Cendant vice chairman, to begin producing daily cash reports and detailed monthly financial statements about their operations, which Mr. Forbes hadn't required at CUC.
By early March, Mr. Silverman still hadn't seen reports for January. Worse, preparations for the 10-K financial filing, due March 31, were stalled. In frustration, Mr. Silverman pulled Ms. Pember, the CUC controller, off the project. To help complete the report, former HFS senior finance officials began working from former CUC offices.
They uncovered some disturbing surprises. Mr. Shelton's budget for 1998 included about $125 million in expected cost savings from the merger -- but there was no breakdown of what expenses might be trimmed or which facilities might close. Typically, companies spell out in significant detail what merger reserves are for.
Mr. Corigliano also revealed that 1997 results would include $25 million in merger reserves that weren't explained -- another possible red flag. But people involved say Ernst & Young assured Mr. Silverman there was proper documentation for the reserves and said the charges weren't material because they were canceled out by other items.
Mr. Silverman had Messrs. Forbes, Shelton and Corigliano sign a standard representation letter saying that the old CUC's numbers were proper. Ernst & Young certified those numbers. Mr. Silverman says that, after he had consulted with Cendant's counsel and its auditors, Deloitte & Touche, "it was appropriate and correct to sign the 10-K," filed March 31.
Still, Mr. Silverman was fuming. Because Mr. Forbes didn't want to meet at Mr. Silverman's midtown Manhattan office, the two met in late March at the St. Regis Hotel. Mr. Silverman told Mr. Forbes that he wanted Mr. Shelton and Mr. Corigliano, Mr. Forbes's top two lieutenants, out. At that meeting, the men also discussed whether Mr. Forbes should ever become CEO.
By late March, Mr. Shelton and Mr. Corigliano had themselves grown disenchanted with Mr. Silverman, and severance negotiations were under way. Word of that soon leaked. Cendant shares swooned. At the request of the New York Stock Exchange, the company halted trading on April 9. During a conference call that afternoon with analysts, Mr. Silverman said that first-quarter earnings met or exceeded Wall Street expectations. He called the planned executive departures typical merger pains.
But even as Mr. Silverman was reassuring analysts, Scott E. Forbes, Cendant's chief accounting officer (and no relation to Walter Forbes), was meeting with the two former CUC managers, Mr. Sabatino and Mr. Speaks. Mr. Monaco arrived after the analysts' call. The managers laid out their allegations of being ordered to cook the books, and Mr. Monaco made the call to Mr. Silverman.
One trick Mr. Speaks described in his subsequent affidavit: recording revenue from sales of memberships in clubs that offer things like discount travel and dining as being from a different product, CUC's PrivacyGuard credit-report service. For arcane accounting reasons, revenue from club memberships must be recognized over time, but PrivacyGuard revenue could be booked immediately. By simply entering club-membership revenue as PrivacyGuard revenue, CUC's overall revenue in that period would be overstated.
Working over Easter weekend, Cendant executives combed through CUC's old books and confirmed potential problems. They informed the two former HFS executives who now sat on the board's four-member audit committee. But Walter Forbes wasn't told of the allegations until April 14, which angered him; as chairman, he felt he should have been informed immediately. Most directors who came from CUC weren't notified until just before Cendant told the world of its discovery. "Ascribe it to a combination of concern about who may have been involved and anger at being deceived," Mr. Silverman says now.
Cendant announced late on April 15 that its discovery of accounting irregularities would force it to cut 1997 earnings by $100 million to $115 million, or about 13%. The next morning, its stock cratered.
At a contentious board meeting that afternoon, Mr. Forbes brought two personal lawyers with him. Some of the 14 directors from CUC were skeptical that the accounting problems were as serious as portrayed, while some of the 14 directors from the HFS side said Mr. Forbes should resign. The board was so split it couldn't agree on any action against Mr. Forbes or Mr. Shelton, who had run CUC's day-to-day operations. After the four members of the audit committee privately read the affidavits from Messrs. Sabatino and Speaks, the board did fire Mr. Corigliano.
In a letter to the board the next day, Mr. Corigliano said he "never knowingly engaged in any accounting or other financial wrongdoing or irregularity or advised or assisted anyone else to do so." Mr. Shelton, through his lawyer, also denies any wrongdoing.
The board hired law firm Willkie Farr & Gallagher and Arthur Andersen to investigate matters. Over the next few weeks, about 200 accountants dug deeper into Cendant's books.
Mr. Silverman and Mr. Forbes, though increasingly at odds, presented a united front in public. At an April analysts' meeting in London, "they got along very well," one participant recalls. "They talked about these accounting issues. Walter seemed just as surprised as Henry."
In May, Mr. Silverman sent a contingent of Cendant executives to explain to major investors how the CEO would clean up the membership business. They made an unusual disclosure. CUC had long claimed annual membership-renewal rates of 65% to 70%. But that's the rate for people who have been members for about 15 months. Typically, CUC doesn't charge a full annual fee until after a three-month trial period; first-timers pay as little as $1 for a trial membership. Only about 45% of people who take trial memberships stick around and pay the full fee. The upshot: The claimed 65% plus renewal rate was overstated -- and neither investors nor Mr. Silverman had known it.
In a newspaper interview that appeared July 4, Mr. Forbes declared: "It's wrong to assume that I'm going anywhere, and I intend to be CEO." Cendant shareholders, bankers, executives and customers deluged Mr. Silverman and board members with calls, faxes and e-mails, most demanding Mr. Forbes's ouster. Richard Smith, chairman and CEO of Cendant's real-estate division, says Mr. Forbes's newspaper interview led one suburban New York bank to drop plans for Cendant to administer its mortgage operation. The bank "had no interest in working with us if Walter [remained] the chairman," Mr. Smith says.
Further, Mr. Silverman and Mr. Forbes stopped talking to each other.
On July 8, the news got uglier. Cendant executives called Mr. Silverman while he was aboard a corporate jet, bound for Fort Worth, Texas, with Gerald Gaston, president and CEO of American Bankers Insurance Group Inc., which Cendant had agreed to acquire. The callers reported that Arthur Andersen had unearthed more possible fraud, and the impact on earnings was far deeper than previously believed.
As he heard the news, Mr. Silverman's face dropped. "What's the matter, Henry?" Mr. Gaston recalls asking. "Didn't your breakfast agree with you?" Mr. Silverman replied that he had to return to New York immediately.
Based on the investigation, Cendant officials say they believe that Mr. Corigliano and Ms. Pember falsified entries themselves and ordered roughly half of CUC's 20 division controllers to do the same by increasing revenue or trimming expenses a few hundred thousand dollars at a time. The CUC executives called the changes "consolidation entries."
People familiar with the Arthur Andersen probe say it found that the scheme had been under way at least since 1995. Cendant officials have concluded that it began after CUC no longer could increase the profitability of its membership business through legitimate operations. The auditors' investigation found that CUC's deception was escalating dramatically -- $100 million in bogus revenue in 1995, $150 million in 1996, and at least $250 million in 1997.
The situation weighed on Mr. Silverman when top Cendant executives gathered for their monthly meeting July 13. Every former HFS unit reported strong results for the second quarter. Mr. Silverman says he turned to Stephen Holmes, a Cendant vice chairman and his first employee when he began HFS in 1990 and said, "we had a great business until we merged with CUC."
That day, rumors of the Arthur Andersen findings began to circulate among investors and Cendant stock slipped again. Early the next morning, Cendant made the wider extent of the fraud public, saying CUC had booked phony revenue for at least three years. It also said Deloitte & Touche had found an additional $200 million of accounting "errors," such things as delaying recognition of insurance claims, and Cendant would have to reduce 1997 results by $190 million to $240 million.
In the fourth quarter, while Mr. Silverman was CEO, Cendant took a charge it now says was inflated. It will reverse up to $300 million of the charge; Cendant says the reversal relates to CUC operations.
Ernst & Young, CUC's longtime auditor, says it did its job properly. "If what Cendant is saying is right, we, too, are the victims of a massive intentional collusive fraud by CUC's former financial management," says Don Howarth, a spokesman.
The Arthur Andersen findings further split the board, and the factions each hired their own law firms. At the same time, Mr. Smith began collecting signatures of 44 top Cendant executives calling on the board to remove Mr. Forbes. Many of the signers had seen their stock options savaged. "We weren't going to sit back and watch somebody dismantle what we spent the last six years building," says Mr. Smith.
Former HFS directors, incensed with Mr. Forbes, also found new ammunition. A routine internal investigation last month turned up several million dollars in questionable expenses over three years, including about $550,000 in undocumented cash advances -- amounting to about $4,000 a week -- between 1995 and 1997, about $500,000 in 1997 charges for use of two airplanes and $100,000 in undocumented American Express charges.
When the full board met again July 28, the scene was tense. According to numerous participants, Arthur Andersen officials detailed, step by step, what they termed a "willful attempt to deceive." Fraud, asked a director? "In layman's terms, yes," replied one official. Deloitte & Touche also gave a presentation, focusing on the separate series of accounting errors. The whole thing took about two hours.
After the presentation, Robert D. Kunisch, a Cendant vice chairman and former HFS executive, asked if the board had any questions for management. There were none. He asked Mr. Shelton if he had any comment. No. He asked the same of Mr. Forbes, who reiterated that he had never known of any accounting problems, according to participants.
"I am as outraged as anyone," Mr. Forbes said.
"Sixty-one percent of your revenue was not there," Mr. Kunisch shot back. "You were the CEO. You had a responsibility to know."
Mr. Forbes, according to participants, didn't reply.
As the meeting progressed, Arthur Andersen and Willkie Farr officials, questioned by directors, said they wouldn't discuss whether their evidence implicates Mr. Forbes or Mr. Shelton until their written report is finished later this month.
A lawyer for Mr. Shelton says his client had no knowledge of or involvement in improper conduct.
One thing the report is expected to examine is an employee expense form signed by Mr. Forbes and Mr. Shelton on Sept. 30, 1997, in which Mr. Forbes sought $596,000 in payment for use of a jet in 1996 and 1995. A handwritten entry on one line says the payment should be charged to merger reserves; a notation specifies the HFS merger. Mr. Forbes says those directions were made after he signed it.
Still split among original loyalties, the board didn't muster the 80% vote required to oust Mr. Forbes. Directors also couldn't find enough evidence to terminate him over the questionable expenses. Instead, Mr. Forbes agreed to resign, saying in a statement that it "is in the best interest of our shareholders and employees to resolve this uncertainty." Because he resigned, he is entitled to about $35 million in cash severance pay and about $12.5 million worth of stock options. Nine of 14 directors who had come from CUC also agreed to resign.
Mr. Forbes Wednesday turned in accounting for the expenses. Cendant has said it can sue to recover any severance paid to Mr. Forbes if he doesn't clear up the expenses, or if he is implicated in fraud.
The U.S. Attorney's office in Newark has been interested in talking to Ms. Pember, Mr. Corigliano and Mr. Shelton. A spokesman for the U.S. Attorney declined to comment. Mr. Corigliano's attorney declined to comment on the U.S. Attorney's probe. Attorneys for Ms. Pember and Mr. Shelton didn't return calls seeking comment on the probe.
In the meantime, Cendant expects to report restated and second-quarter earnings Thursday.
Senior managers like John Russell, chief executive of the lodging division, are trying to rally employees with breakfasts and a softball challenge. To try to rebuild Cendant, Mr. Silverman is considering selling some former CUC units, and Wednesday agreed to sell a former CUC publisher of classified advertising for $523 million in cash and stock.
"This has been very difficult," says Mr. Silverman, whose personal net worth has fallen by about $800 million because of Cendant stock's plunge. But, he adds, "this is just business. It has nothing to do with life or death. It's just money."
--Mark Maremont and Elizabeth MacDonald contributed to this article. |
