Playing the earnings shell game

The bankruptcy of Lernout & Hauspie Speech Products NV could make the Belgian-American software maker the new poster child of erroneous financial statements.

Now $500 million in debt and with its stock down more than 75% for the year, the company is being investigated for reporting revenues over the past few years where no sales existed.

The company, facing more than a dozen securities fraud lawsuits filed on behalf of shareholders, has admitted to “errors and irregularities” in its prior quarterly earnings reports.

Michael Lange, partner at the Boston law firm of Berman DeValerio & Pease, says Lernout & Hauspie is an example of a rapidly growing trend: The release of misleading financial statements by companies trying to gain an edge in the market.

“We’re seeing a rash of restatements,” Mr. Lange says. “It’s at an all-time high.”

Since 1997, more than 360 companies, or 1% of all filings, have restated their annual financials, according to the Securities and Exchange Commission.

Some observers call the increased number of restatements a brutal reality of a modern and bustling economy, where the flow of information seems to never cease and too much emphasis is placed on a company’s stock market performance.

Others prefer to view the restatements as little more than blatant fraud, which ultimately leads to many layers of litigation.

litigation results

Since 1996, when the Private Securities Litigation Reform Act of 1995 kicked in, the earnings restatements have almost always resulted in securities fraud lawsuits.

According to National Economic Research Associates Inc., the litigation reform act that was designed to reduce the number of frivolous lawsuits coincided with a dramatic increase in the number of shareholder lawsuits related to accounting fraud.

Its data show that between 1990 and 1995, 35% of all shareholder lawsuits included allegations of accounting fraud. But since the litigation reform act was introduced, 53% of all shareholder lawsuits have had allegations involving accounting fraud.

“Whenever we see a restatement of earnings, bells and whistles go off,” says Mr. Lange, whose law firm, which specializes in securities class actions, has filed one of the more than a dozen securities fraud lawsuits on behalf of shareholders against Lernout & Hauspie.

According to Mr. Lange, the recent Chapter 11 filing by Lernout & Hauspie “doesn’t affect the vigor with which we’re going after the company; it just means a fight on two fronts instead of one.

“The bankruptcy really doesn’t change the fact that shareholders were seriously damaged,” he says, referring to the way inaccurate financial statements can affect the stock price of a company.

Securities law specialists say the litigation reform act requires specific evidence of fraud.

“Whenever there’s a restatement, you will always see a lawsuit,” says Greg Joseph, head of litigation at Fried Frank Harris Shriver & Jacobson in New York. “Irregularities means misconduct, and subsequent litigation is almost a given.”

Randall Steinmeyer, a San Diego associate with the New York law firm of Milberg Weiss Bershad Hynes & Lerach, says: “Any time you have financial statements that a company later admits are false, it dramatically bolsters a securities claim.

“The stock market is risky enough without companies releasing inaccurate financial information,” Mr. Steinmeyer says.

Some securities lawyers point out that while earnings restatements result in lawsuits, the lawsuits are not the problem.

Arthur Stock, a partner at the Philadelphia law firm of Berger & Montague, suggests that the problem is rooted in the executive compensation structures that place a disproportionate emphasis on stock performance.

Mr. Stock adds that with an increased number of publicly traded companies and more people investing in the stock market than ever before, the high number of restatements and accompanying lawsuits may be deceiving.

“We have more clients now, but when more people are invested, more people care,” he says. “The securities class-action business has not grown as fast as the economy.”

When it comes to the cause of the restatements, a less experienced and less diligent executive management team is often cited.

According to Mr. Lange, there is often a mind-set within the companies that states: “Let’s just make the quarterly numbers look good and we’ll deal with it later.”

accounting is faulted

John Forelli, senior vice president in institutional money management at John Hancock Financial Services Inc. in Boston, agrees that much of the restatements are the result of “too-aggressive accounting practices.”

But, he says, there are also many gray areas regarding accounting, particularly with the new technology companies that have long-term servicing contracts, upfront revenues and recurring revenues.

“It’s definitely a case-by-case basis,” he says. “But if the accounting rules were tighter, then companies would have less variability.”