Friday, April 02, 2010

New False Disclosures about Overstock.com's "Tax Dodge" Found in 10-K

Patrick Byrne has a headache and a hangover
Updated to include new details at 10:40 PM:

Just about every time I examine Overstock.com's (NASDAQ: OSTK) financial reports, I find false, misleading, inconsistent, and contradictory disclosures. In Overstock.com's recent 2009 10-K report, I found yet another false financial disclosure relating to a variable interest entity set up by the company to buy jewelry in 2004, which was later dubbed “Operation Heist and Freeze" by CEO Patrick Byrne.

In January 2010, investigative journalist Roddy Boyd exposed a "tax dodge" scheme by Overstock.com involving that variable interest entity which led to former CFO David Chidester's departure from the company on the following day.

Originally, Overstock.com claimed that in August 2004, the company entered into an agreement to lend a certain sum of money to a variable interest entity. The company improperly omitted that material financial disclosure from its Q3 2004 10-Q and finally disclosed the arrangement in its 2004 10-K report.

However, it now turns out that Overstock.com entered into the agreement to lend a certain sum of money to the variable interest entity in "April 2004" not in "August 2004" as originally reported. Therefore, Overstock.com improperly omitted the material financial disclosure from two quarterly financial reports, not one (Q2 2004 10-Q and Q3 2004 10-Q).

In addition, Overstock.com's 2004 10-K variable interest disclosure was confusing and misled investors about the amount of money the company agreed to lend that entity and actually lent that entity.

I simply compared Overstock.com's variable interest entity disclosure in its recent 2009 10-K report to its disclosure in its 2004 10-K report.


Comparing Overstock.com 2004 and 2009 10-K disclosures

In Overstock.com's 2004 10-K report, the company made the following disclosure about the variable interest entity set up to buy jewelry:
20. VARIABLE INTEREST ENTITY
In August 2004, the Company entered into an agreement which allows the Company to lend up to $10,000 to an entity for the purpose of buying inventory, primarily to supply a new category within our jewelry store which allows customers purchasing diamond rings to select both a specific diamond and ring setting. In November 2004, the Company loaned the entity $8,400. The promissory note bears interest at 3.75% per annum. The Company will also receive fifty percent (50%) of any profits of the entity. Interest shall be due and payable quarterly on the fifteenth day of February, May, August and November, commencing on November 15, 2004 until the due date of November 30, 2006, on which all principal and interest accrued and unpaid thereon, shall be due and payable. The promissory note is collateralized by all of the assets of the entity.
The Company has a ten year option to purchase ("Purchase Option") 50% of the ownership and voting interest of the entity. The exercise price of the Purchase Option is the sum of (a) one thousand dollars, and (b) $3.0 million, which may be paid, at the Company's election, in cash or by the forgiveness of $3.0 million of the entity's indebtedness to the Company.
Note: bold print and italics added by me. 
In Overstock.com's 2009 10-K report, the company made the following disclosure about the Variable Interest Entity set up to buy jewelry:
26. DECONSOLIDATION OF VARIABLE INTEREST ENTITY
In April 2004, the Company entered into an agreement which allowed the Company to lend up to $10.0 million to an entity for the purpose of buying diamonds and other jewelry, primarily to supply a new category within the jewelry department which allowed customers purchasing diamond rings to select both a specific diamond and ring setting. Under the agreement, the Company was to receive fifty percent (50%) of any profits of the entity. In addition, the Company had a ten year option to purchase ("Purchase Option") 50% of the ownership and voting interest of the entity. The exercise price of the Purchase Option was the sum of (a) one thousand dollars, and (b) $3.0 million, which may have been paid, at the Company's election, in cash or by the forgiveness of $3.0 million of the entity's indebtedness to the Company.

The entity was evaluated in accordance with FASB ASC Topic 810-10-65-2, Consolidation of Variable Interest Entities, and it was determined to be a variable interest entity for which the Company was determined to be the primary beneficiary. As such, the financial statements of the entity were consolidated into the financial statements of the Company.

Note: Bold print and italics added by me.
The 2004 10-K disclosure states that Overstock.com entered into an agreement to lend the variable interest entity “$10,000” and actually loaned that entity “$8,400.”

Even more troubling is that in the very next paragraph of the 2004 10-K report, Overstock.com stops rounding off to the nearest thousand in disclosing the exercise price of the purchase option in the amount of "$3.0 million." That inconsistent rounding in Overstock.com’s financial disclosures originally misled many investors into believing that Overstock.com agreed to lend the variable interest entity “10,000” not “$10.0” million, loaned the entity “$8,400” not “$.8.4 million."

You need to dig deep elsewhere in the 2004 footnotes to find out that Overstock.com dropped three zeros to report how much money the company agreed to lend and actually lent the variable interest entity. In other words, finding the real amount whether its “10,000” or "10.0 million" is a very difficult task for investors.

In its Q3 2005 10-Q report, Overstock.com finally revised its confusing anf misleading variable interest entity disclosure. However, the company still claimed that it entered into an agreement to lend the variable interest entity "$10.0 million" in "August 2004,' not "April 2004" as later reported in its 2009 10-K report. As usual, Overstock.com quietly revised its disclosures without explaining any revisions and corrections.

Roddy Boyd Exposes "Tax Dodge"

In January 2010, The Big Money published an article by investigative reporter Roddy Boyd Overstock.com's efforts to evade paying New York State sales tax in what was known as "Operation Heist and Freeze." Below is an excerpt from that article:
But the truth is much simpler: The deal seems to have been a tax dodge. The joint venture, struck with Moshe Krasnanski and his brother-in-law Mayer Gniwisch—a pair of veteran diamond merchants whom Byrne referred to as “Our Lubbavitcher friends”—had nothing to do with efforts to minimize accounting losses. In an e-mail to the board of directors, Byrne dubbed the process of recruiting the pair, who had set up the profitable online diamond-seller Ice.com, “Operation Heist and Freeze.” According to a memo, Overstock general counsel Jonathan Johnson prepared for the board of directors on July 13, 2005, the company’s VIE was designed to avoid a “nexus in the State of New York for sales tax purposes,” which means that the company would not have to collect, and pay out, sales taxes in the state. The diamond sales effort never really went anywhere for Overstock, and it was closed out during the holidays of 2006 with about $567,000 in accumulated losses, according to an internal balance sheet for the joint venture.
Note: Bold print and italics added by me.
In addition, Roddy Boyd's article detailed how Overstock.com's executives intentionally hid material internal control weaknesses from investors. Overstock.com's subsequent three restatements of financial reports in three years confirmed that the company had material weaknesses in internal controls.

A day after Roddy Boyd's article was published, former CFO David Chidester resigned from the company. It turns out that a few weeks later, former Treasurer Rich Paongo also left Overstock.com, but the company failed to report his departure.

In my last blog post, I detailed how CEO Patrick Byrne and company President Jonathan E. Johnson lied to investors in a failed effort to cover up violations of Generally Accepted Accounting Principles (GAAP) by Overstock.com that were exposed in this blog. Eventually, Overstock.com was forced to restate its financial reports to correct those GAAP violations and the company finally admitted that its accounting was "inappropriate."

Two days ago, Investigative reporter and blogger Gary Weiss uncovered contradictory disclosures in Overstock.com's 2009 10-K report about a criminal investigation of the company's advertising practices in California.

KPMG "expressed an adverse opinion on the effectiveness of the Company's internal control over financial reporting" but still issued a clean audit opinion. Back in my criminal days at Crazy Eddie, Main Hurdman, who later became part of KPMG, noted material weaknesses in our internal controls but still issued a clean audit opinions. Eventually, a massive fraud was uncovered at Crazy Eddie. The dumb-dumbs at KPMG still seem to believe that they can conduct a proper audit in the absence of adequate internal controls. It did not work back in the day and it won't work now.

There are many other black holes in Overstock.com's financial reporting not yet uncovered or ignored by KPMG. Those black holes will be the subject of future blog posts. I am just getting warmed up.

Written by:

Sam E. Antar

Disclosure:

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes, simply because I could.

If it weren't for the efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

I do not own Overstock.com securities short or long. My research on Overstock.com and in particular its lying CEO Patrick Byrne is a freebie for securities regulators and the public in order to help me get into heaven, though I doubt that I will ever get there anyway. I will probably end up joining corporate miscreants such as Patrick Byrne in hell.

In any case, exposing corporate crooks is a lot of fun for a forcibly "retired" crook like me. Analyzing Overstock.com's financial reporting is a forensic accountant's wet dream and Patrick Byrne is about to become the SEC's new orgasm.

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