The Valuation Treadmill

POMERANTZ MONITOR | NOVEMBER DECEMBER 2022

The Valuation Treadmill by Professor James J. Park

This is an abbreviated version of an article to be published in the Securities Regulation Law Journal. Despite the plaintiffs’ securities bar’s success, over the last decades, in recovering billions of dollars for defrauded investors and effecting important corporate governance reforms, corporate securities fraud persists.

The history and current state of “cooking the books” is masterfully explored in The Valuation Treadmill by Professor James J. Park of UCLA Law School. Park blames the persistence of such fraud primarily on corporations’ drive to meet “valuation metrics” – especially quarterly earnings projections – by fudging numbers to report results consistent with such forecasts.

The Frauds

Park analyzes iconic cases of projection-focused frauds, recounting the motivation behind each, the methods used, and the ultimate fallout. These include frauds related to Penn Central’s demise in the 1970’s; Apple’s failed launch of the Lisa computer in the late 1980’s; Xerox’s unsuccessful efforts to keep pace with computer-driven technology in the late 1990’s; Enron’s efforts to monetize energy supply contracts in the early aughts; Citigroup’s sinking from overloaded subprime debt in the late aughts; and GE’s opaque, cobbled-together conglomeration of enterprises, which (by deft skill or sleight of hand) enabled it to generate 10 years of consistent growth, until, abruptly, it did not.

The Obsession with Projections

Park decries analysts’ and investors’ focus on the feedback loop of the “valuation treadmill”:

“[S]ecurities fraud emerged as a significant risk for public companies as investors changed how they valued stocks. As investors adopted modern valuation models and attempted to develop projections of a corporation’s ability to generate earnings into the future, it became more important for public companies to meet market expectations about their short-term performance.”

This focus on the future, Park asserts, has created structural incentives for companies to inflate prospects, which was not historically the case. He lays blame on money managers and outside securities analysts as well as on corporations themselves. The Valuation Treadmill also asserts that executive compensation has become a factor in the pressure to meet quarterly projections. In the 1970’s, CEOs, missioned to maintain stable growth, were compensated primarily in cash. By the aughts, CEOs had morphed into entrepreneurial titans setting the course for expansive growth, with 66% of their compensation in stocks and options.

How They Did It – The Projections/Inflation Toolbox Park

Park identifies several devices management has used to inflate results and meet forecasts, including:

Skewed Unbundling – improperly allocating bundled hardware/software and service contracts in order to maximize short-term revenue recognition and minimize long-term amortizations, as in Xerox and Comverse Technologies.

Round-tripping – entering into contracts to essentially swap revenues.

Reciprocal Timing Transactions – to forestall reporting lower-than-expected results, a company “sells” goods to third parties near the end of a quarter, with the understanding that the company will buy back the goods once the new quarter begins.

Cookie Jar Reserves – manipulating results when times are good by increasing reserves which are expensed against earnings, and then releasing those reserves in less profitable times, thereby “smoothing out” reported results.

Earnings Management – an arguably more sophisticated method of smoothing out reported earnings by which companies sell assets and purchase new revenue-generating businesses when they need to produce additional income for a period. Such buying and selling enables a company to exercise discretion on how much to assign to goodwill and deferrals.

Proposed Solutions

The Valuation Treadmill also proposes several solutions to projections-triggered fraud. Rather than weaning the market from reliance on projections, Park urges that all corporations be compelled not only to provide quarterly projections, but also to disclose the basis for such projections. Doubling down, he further urges that companies be compelled to update their projections, considering significant intra-quarter developments. To address the risk of earnings management, Park also recommends that the SEC develop rules clarifying when companies cross the line into deceit.

A threshold question to Park’s proposals remains: Will mandating quarterly projections continue to skew the focus to “short termism” and risk long-term sustainability? Such short-sightedness accounts for the significant decline in corporate investment in research and development, whose payoff is generally years down the line, and has led to reliance on acquisition of start-ups (only recently raising antitrust monopolization concerns). Several alternatives to Park’s proposals are considered below.

The Business Roundtable Remedy – fewer projections

Park acknowledges, but rejects, the proposal forwarded by Jamie Dimon and Warren Buffet on behalf of the Business Roundtable, that companies be barred from issuing quarterly projections altogether, to enable them to voluntarily manage investor expectations during downturns, while reducing the weight investors assign analyst projections.

The UK Remedy – fewer quarterly reports

Both the Business Roundtable and Park ignore the possibility of reducing short-termism by companies issuing historic results less frequently. Companies listed on the London Stock Exchange fi le financial reports only semi-annually. From 2007-2013, the UK experimented with quarterly reports, but reversed that requirement in 2014. Quarterly reporting maximizes contemporaneous information, but increases the risk of short-termism and securities fraud, which is far less frequent in the UK.

Clawbacks

Another solution not considered by Park would be enhanced enforcement of “clawbacks.” The SEC is empowered to recover compensation paid to executives for conduct underpinning whistleblower complaints. Such clawbacks remain rare, though, and there is no private right of action empowering investors to directly sue for such recompense – investors can only sue derivatively on behalf of a company. Perhaps if executives were held more accountable for the bonuses they pocket from reporting inflated results, they might think twice before “cooking the books” to meet quarterly projections.

Several Questions Raised by Park’s Proposals

Which Projection Factors Should be Disclosed

If disclosure of quarterly forecasts and supporting assumptions are to be mandated, companies will need to beef up internal controls. Myriad prognostications inform forecasts: likely sales, returns, bad debts, currency fluctuations, interest rates, wages, employee turnover, etc. If each contributes to projection calculations, to what degree should each be disclosed? Moreover, is there a risk that increased costs for control-related personnel and procedures will lower profits?

Should Disclosure to Bankers Be Shared

Before reinventing the wheel, it could be helpful to understand what types of forecasts companies routinely provide their lending banks, and to consider compelling their disclosure. On the other hand, having managed a contingency fee law firm for several years, I know that forecasting is more art than science. Executives will be in a structural bind: As salespeople, they need to set goals to motivate personnel and maximize performance; but projections of likely results will need to be tempered when presented to risk-averse investors.

Should Upside Revisions Be Disclosed?

Park’s proposal to impose a duty to update might be a welcome addition to the valuation tool kit. But should that duty be bilateral, i.e., if matters look better than previously projected as the quarter nears an end, should the company be compelled to disclose revised upbeat projections? The pressure to commit fraud might intensify if last-minute sales fail to materialize after such upward adjustments. Market prices tend to be volatile, particularly when companies miss consensus forecasts by even small amounts. A mandatory duty to update projections could have unintended consequences on market prices or management behavior.

Conclusion

The Valuation Treadmill is an invaluable addition to the study of securities fraud trends over the past 50 years, along with ambitious proposals to curtail such misconduct in the future.