No, it’s not an episode of Top Chef, but it is about “cooking the books.” And those are just some of the ingredients and tools used by Brixmor Property Group, a publicly traded REIT, and four of its executives to do the cooking: manipulation of a key non-GAAP financial measure, according to this SEC complaint and order and, even more to the point, this SDNY criminal indictment of the executives. As alleged, management sought to create the impression that a static pool of its existing properties showed steady and predictable income growth across a number of quarters. In contrast, however, Brixmor’s actual income growth rate was “volatile and frequently fell above or below the company’s publically issued guidance range” for the period. So, according to the order, the company architected the desired illusion—touted as its “secret sauce”—by engaging in some “sausage-making” with regular hits to the “cookie jar.” While it doesn’t sound very appetizing, it did create the desired deception—until, of course, it didn’t. The lesson is that manipulation of a non-GAAP measure, together with violations of GAAP, to mislead the public can be trouble—and perhaps even criminal. Although cases of accounting fraud may not be as common as they once were, this case should serve as a reminder that the SEC and the Justice Department are still on the lookout for it.
One of the most important non-GAAP financial measures that REITs typically report is “same property net operating income,” or “SP NOI,” defined in this case as “rental income less rental operating expenses such as property operating expenses, real estate taxes, and bad debt expense” for a pool of the same properties. The executives were alleged to have engaged in an accounting fraud scheme to convey stable growth by “smoothing” the SP NOI numbers so that they regularly fell squarely within the company’s guidance.
And the company’s executives hyped the company’s consistency. For example, during a quarterly earnings call, an executive told the analysts that we “don’t believe in an under-promise and over-deliver approach. By having wholly owned assets with contractual leases we can forecast earnings accurately….we have a steady state portfolio with a large same property pool that is delivering consistent organic growth….As I said, we are consistent, transparent and easy to understand.”
But, the order states, those consistent numbers did not reflect the reality of the company’s operations. Rather, according to the order and the indictment, the company manufactured those numbers, as described below. First, the executives created a “cookie jar” account. When it appeared that income would exceed the guidance, the company improperly delayed recognition of revenue that should have been recognized under GAAP, instead “storing” the revenue for future use in a particular account that company personnel actually referred to as the “cookie jar.” (I know, hard to believe—why not just call it the “arrest me” account?) For example, the company would store in the cookie jar deferred revenue of uncertain status, such as payments for billed expenses that were expected to be disputed. Instead of recognizing the payments for those expenses when they were collected, as required by GAAP, the executives delayed recognition, storing the payments in the cookie jar account for extended periods. They then dipped into the cookie jar by reclassifying and improperly recognizing that revenue when they wanted to give the SP NOI a “boost” to fall within the guidance.
Second, the company represented, consistent with industry practice, that SP NOI specifically excluded one-time payments received for early lease terminations, referred to as “lease settlement income” (LSI). However, contrary to their public representations, when they needed to make the numbers, the executives included LSI in the SP NOI, either by amortizing the LSI over the lease term or reclassifying portions of LSI as “other income.”
Third, the company sometimes improperly reduced the SP NOI for the prior comparative period to put the growth rate for current period within the guidance. When an alert IR employee asked about the basis for removing properties from the same-property pool to reduce income from the prior comparative period, the executives asked how she found out and warned that she “must not be given access to how we make the sausage.” They were later congratulated for creating “LLC Bratwurst at its Finest,” to which one of the executives “responded with an image of a man holding a batch of sausage.”
Ultimately, as a result of multiple manipulations, the company reported “fraudulent [SP-NOI] Growth numbers in eight out of nine” quarters. The scheme was uncovered when an employee submitted an anonymous complaint to the Audit Committee through the company’s internal compliance reporting system. The Audit Committee then engaged outside professionals to conduct an internal investigation, terminated the four executives and initiated a number of remedial measures including: “automating much of the process for calculating its non-GAAP measures; improving its reconciliation processes related to balance sheet accounts; increasing the segregation of duties within the accounting department; strengthening its internal audit function; and requiring ethics and fraud awareness training for all new employees with accounting or financial reporting responsibilities.”
The company also self-reported to the SEC staff. The order, which found that the company had violated Exchange Act Sections 10(b) and 13(a) as well as Reg G, required the company to engage an independent consultant and pay a $7 million penalty. The SEC charged the four executives with violating or aiding and abetting violations of the antifraud and books and records provisions of the Exchange Act, as well as violations of Reg G, and sought permanent injunctions, disgorgement plus interest and penalties, and officer-and-director bars. And, even more seriously, as described in this press release, the U.S. Attorney for the SDNY charged the four executives with conspiracy to commit securities fraud, securities fraud, making false statements in SEC filings and filing false certifications. The “securities fraud, false filings charges, and false certification charges each carry a maximum prison term of 20 years. The charge of conspiracy carries a maximum prison term of five years.” Two of the officers have already pleaded guilty to some of the counts.