Is Green Mountain Coffee Going to Get Roasted by its Exes?

Last week, lawyers representing investors filed an amended class-action lawsuit against Green Mountain Coffee Roasters (NASDAQ: GMCR) and members of its management containing new allegations of wrongdoing based on information:

…obtained from confidential witnesses, including former Green Mountain Coffee Roasters, Inc. ("GMCR" or the "Company") and M.Block & Sons, Inc. ("MBlock") employees…. [Emphasis added.]

Note: Download the amended class-action complaint here.

The three exes

In law enforcement circles, there is a term known as the “three exes” for ex-lovers, ex-employees, and ex-business associates. In many cases, such informants provide crucial information to law enforcement agencies that investigate and prosecute white-collar crime. In this case, the amended complaint is based on detailed first-hand accounts of alleged wrongdoing by the company obtained from several ex-employees and ex-business associates who are identified as "confidential" witnesses such as CW 1, CW2, and CW 3. One such ex-employee identified as "CW 6" is a former Vice President of Operations for Green Mountain Coffee.

The amended complaint identifies various alleged schemes employed by Green Mountain Coffee to deliberately violate Generally Accepted Accounting Principles (GAAP) and prematurely recognize income on the shipment of products to M. Block, its primary fulfillment vendor.

CNBC Senior Stock Commentator Herb Greenberg wrote in his blog that:

My take: I generally ignore class action lawsuits, but they're hard to dismiss out of hand when they include allegations from multiple former employees.

Is M. Block a "black box" entity used to inflate earnings?

The complaint effectively describes M. Block, in what is known in fraud investigation circles, as a "black box entity" used by fraudsters to play shell games with inventory and inflate income. Back in the day at Crazy Eddie, we took advantage of our cozy relationship with certain third party entities and effectively used them as "black box entities" to help us inflate our earnings.

For example, the amended complaint alleges that:

64. Information provided by former GMCR and MBlock employees described the companies' relationship as one where GMCR dictated their business dealings and being something other than on an arms-length basis.

[Snip]

66. A former regional sales manager for GMCR from late 2008 until late 2010 ("CW2") stated that anyone at the Company would acknowledge that MBlock was, in essence, a captive company and would do as GMCR instructed. CW2 indicated that his/her current employer is careful in its dealings with MBlock because it is aware of the close relationship between GMCR and MBlock.

One of the alleged schemes detailed in the amended complaint involves the shipment 150 truck loads of merchandise to M. Block to inflate revenues in the quarter ended December 26, 2009:

70. CW1 indicated that GMCR improperly recognized revenue on 150 truck loads of product that was shipped to MBlock during the quarter ended December 26, 2009. This former GMCR manager stated that he/she and other Company employees, including the Company's global transportation manager, were unable to locate the requisite paperwork, including purchase orders, material requisition orders, or product shipment authorizations, traditionally used by GMCR to validate the sale.

71. Specifically, CW1 indicated that because there was no order for those products, no payment was ever made on the 150-truckload shipment. In addition, the order was not listed on the Company's production forecast schedule and employees who worked under CW1 not only saw the trucks go out, but visited MBlock and saw its warehouses filled to the rafters with K-Cups. CW1, who estimated that the value the revenue recognized on the foregoing improperly recorded transaction to be between $7.5 and $15 million dollars, indicated the following GMCR executives were aware of the shipment: Vice President of Operations Jonathan Wettstein (who regularly provided updates to CEO Blanford), SBCU President McCreary and Vice President of Finance Tina Bissonette.

72. As a result of the foregoing, GMCR violated GAAP's criteria of revenue recognition, which provides that the conditions for revenue recognition ordinarily are met when the seller's price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer's obligation to the seller is not changed in the event of theft or physical destruction of the product; the buyer has economic substance apart from the seller; the seller does not have significant future performance obligations to the buyer; and the amount of future returns, if any, can be reasonably estimated. See, e.g., Accounting Standards Codification 605.

73. Consequently, GMCR violated its revenue recognition policy, as disclosed in the 2010 Form 10-K, when it prematurely recorded revenue on shipments of product to MBlock:

The Company recognizes revenue when the fulfillment entities ship the product based on the contractual shipping terms, which generally are upon product shipment, and when all other revenue recognition criteria are met. 

74. CW1 also indicated that GMCR had earlier changed the wording of its revenue recognition policy because the auditors had found discrepancies and senior management was thus aware that GMCR was accounting for revenue incorrectly.

75. In addition, a former regional sales director for Keurig between 2004 and the fall of 2010 ("CW 5"), indicated that distributors were unhappy with certain sales made to them by MBlock and that during a March 2010 sales conference call with regional directors, Keurig Vice Presidents Chris Stevens, Dan Cignarella and Dave Manly denied sales to distributors had been made by MBlock.

76. A former Vice President of Operations for GMCR during 2010 ("CW6"), stated that while the accounting department in Vermont told CW6 to book shipments to MBlock as a sale, the SEC [Securities and Exchange Commission] questioned the existence of an arms-length relationship between GMCR and MBlock. In fact, CW6 did not know if MBlock ever owned the products shipped to it. [Emphasis added.]

When did the Securities and Exchange Commission start investigating Green Mountain Coffee?

The amended complaint alleges that the company knew it was being investigated by the SEC months before it was disclosed to investors. On September 28, 2010, Green Mountain Coffee issued an 8-K report claiming that:

On September 20, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information. Based on the request, the Company believes the focus of the inquiry concerns certain revenue recognition practices and the Company’s relationship with one of its fulfillment vendors. The Company, at the direction of the audit committee of the Company’s board of directors, is cooperating fully with the SEC staff’s inquiry. [Emphasis added.]

However, the amended complaint takes issue with Green Mountain Coffee's disclosure:

68. Moreover, although the September 28, 2010 Form 8-K indicates that, "[o]n September 20, 2010, the staff of the SEC's Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information," the above-noted former employee has stated that by no later than the first week of May 2010, he/she was contacted by Company employees who asked if he/she had been had been the whistleblower in an SEC investigation of GMCR.

69. Accordingly, Company employees contacted the confidential witness concerning an SEC investigation five months prior to the issuance of the September 28, 2010 Form 8-K, which disclosed that the SEC informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information on September 20, 2010. [Emphasis added.]

From my experience at Crazy Eddie and later consulting work, I learned that the SEC usually communicates its concerns to targeted companies before sending an official notification of inquiry or investigation to them.

Alleged Illegal Insider Trading

Further, the amended complaint alleges that Michelle Stacy (President of Keurig operating segment) and Scott McCreary, (President Specialty Coffee Business Unit) engaged in illegal insider trading stemming from recent stock sales starting in August 2010:

7. Approximately one month earlier, both Stacy and Scott McCreary ("McCreary"), the President of GMCR's other business division, the Specialty Coffee Business Unit ("SCBU"), unloaded a total of 230,000 Company shares for proceeds of more than $7.5 million. These sales, which also occurred shortly before the Company's official announcement of an SEC inquiry, were made after the SEC's initial contact with GMCR. Prior to these sales, there had not been significant insider trading activity since June 2009.

In the weeks before Green Mountain Coffee claims it was notified about the SEC inquiry, Michelle Stacy and Scott McCreary simultaneously exercised options and sold large amounts of shares. On August 13, 2010, Michelle Stacy exercised 30,000 options at $6.20 per share and simultaneously sold those shares at $30.95 per share for gross proceeds of $928,500. On August 18, 2010, Scott McCreary exercised 200,000 options and $1.47 per share and simultaneously sold his shares at $33.08 per share for gross proceeds of $6.616 million. On September 13, 2010 Michelle Stacy exercised another 5,000 options at $6.20 per share and sold those shares at $35.40 for gross proceeds of $177,000.

On September 20, 2010, Green Mountain Coffee claimed that it was notified by the SEC of an informal inquiry concerning its “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” On September 21, 2010, Michelle Stacy exercised 5,000 options and immediately sold her shares at $37 per share.

On September 28, 2010, Green Mountain Coffee disclosed the SEC inquiry to investors. In addition, the company disclosed that it discovered an "immaterial accounting error" involving its K-Cup margin percentages which resulted in a $7.6 million cumulative overstatement of pre-tax income in financial reports issued from 2007 to June 26, 2010. The company’s disclosure was vague about when it discovered K-Cup margin error:

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit.

In my blog, interviews by fellow Seeking Alpha contributor Ilene (here and here), and in a televised interview on WCAX TV Vermont, I expressed my concern about the possibility of illegal insider trading by Michelle Stacy and Scott McCreary based on the timing of their stock sales.

Michelle Stacy sold her shares a day after Green Mountain Coffee claimed it was notified by the SEC of its inquiry but seven days before that inquiry was disclosed to investors. Green Mountain Coffee did not disclose exactly when it initially discovered its K-Cup margin error. Usually weaknesses in internal controls that cause accounting errors are discovered months or weeks in advance of the disclosure of such errors to investors.

On October 28, 2010, Stacy belatedly filed amended Form 4 reports and claimed that her September 13 and September 21 sales of stock were "affected pursuant to a Rule 10b5-1 trading plan" established on August 13, 2010.  A Rule 10b5-1 trading plan provides certain safe harbors which help executives defend against potential allegations of illegal insider-trading by removing their discretion to decide when their stock is bought or sold.

The amended complaint took issue with the timing of Michelle Stacy and Scott McCreary's stock sales:

103. Prior to these sales, there had not been significant insider trading activity since June 2009. Not only did both division presidents sell the majority of their shares, but Stacy did so the day after the SEC's information request and one week before GMCR made the SEC inquiry public.

104. Even worse, in October 2010, Stacy amended her Form 4s for the August and September sales, claiming that she forgot to include in the original Form 4s that the sales were made pursuant to a Rule 10b5-1 trading plan adopted on August 13, 2010. Not only did the Company fail to inform the SEC of the plan on the day it was adopted, but it failed to disclose the plan when Stacy's Form 4 for the $928,500 sale was filed a mere four days after its adoption.

In a follow up blog post, I noted that:

If a corporate executive already has nonpublic knowledge of certain adverse events such as undisclosed weaknesses in internal controls, accounting errors, or an SEC inquiry, a 10b5-1 plan cannot provide a safe harbor against illegal insider trading allegations.

As detailed above, the amended class-action complaint alleges that Green Mountain Coffee executives knew that it was being investigated by the SEC months as early as May 2010, which was about 90 days before Michelle Stacy and Scott McCreary sold their stock and before Stacy claims she set up a 10b5-1 trading plan.

According to the SEC:

Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.

If the class-action lawyers or the SEC can prove that Michelle Stacy or Scott McCreary knew about any material weaknesses in internal controls involving financial reporting, any material accounting errors, or an impending or actual SEC investigation and then sold their stock before it was disclosed to investors, they could be successfully prosecuted for illegal insider trading. The class-action lawyers and the SEC do not have to prove that Michelle Stacy or Scott McCreary knew of and participated in any alleged schemes to improperly inflate revenues and income to successfully prosecute them for illegal insider trading.

Closing comments

The amended complaint cites reporting by me and fellow Seeking Alpha contributor Jason Merriam:

GMCR's accounting practices have also garnered attention from the financial press. For example, in a February 13, 2011 Seeking Alpha article entitled "Green Mountain Coffee: Only Thing Brewing Is Trouble," author Jason Merriam, noted "[t]he accounting practices at Green Mountain Coffee Roasters (GMCR) are not baffling ... they are downright ludicrous." Similarly, on February 15,2011, Sam Antar began his Seeking Alpha article, entitled "More Mucky Disclosures For Green Mountain Coffee Roasters," with the following sentence: "Just about every time I examine financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I find new troubling accounting practices and financial disclosures. [Emphasis added.]

In my Seeking Alpha article, I detailed how starting in the quarter ended December 25, 2009 Green Mountain Coffee restated its segment numbers without disclosing it to investors months before it announced the SEC inquiry and certain accounting errors. The company's restatement of segment numbers may indicate that it was aware of material weaknesses in internal controls over in its financial reporting as far back as 2009.

In another blog post, I questioned whether Green Mountain Coffee correctly determined that its K-Cup margin error was an "immaterial accounting error" when it was initially disclosed on September 28, 2010. My analysis showed that the K-Cup margin error caused Green Mountain Coffee to overstate profits and beat analysts' consensus earnings expectations in the quarter ended March 27, 2010. According the SEC Staff Accounting Bulletin No. 99, Green Mountain should have considered its K-Cup margin error as a material accounting error on September 28, 2010 and it should have immediately disclosed to investors that it was going to restate its financial reports from 2007 to 2010 to correct that error.

Instead, Green Mountain Coffee waited until November 19, 2010 to inform investors that it was going to restate its financial reports when it disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income. These errors plus the K-Cup margin error resulted in a total overstatement of $10.1 million in pre-tax income. This time, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

In addition, the company claimed that its own internal investigation cleared it of misconduct. I told Ilene, fellow Seeking Alpha contributor and editor at Phil's Stock World:

In any case, I am naturally suspicious of self-proclaimed absences of wrongdoing without thorough outside independent examination. Back in the old days at Crazy Eddie, we conducted a similar internal inquiry with help from our auditors into certain allegations of wrongdoing involving a supplier and proclaimed ourselves clean… Management and auditors have little incentive to report their own foul-ups.

To date, Green Mountain Coffee has not specifically disclosed details of who conducted the internal investigation, how it was conducted, or why the company missed certain red flags. For all we know, it could be the janitor who conducted the company's internal investigation.

In my last blog post, I wrote an open letter to Green Mountain Coffee's Chief Financial Officer Frances G. Rathke questioning unusual numbers reported for its Timothy's Coffee subsidiary. I questioned how the company missed a 75% overstatement of revenues for Timothy's Coffee in the quarter ended December 26, 2009 and how the subsidiary was able to report income before taxes in excess of revenues in the quarter ended June 26, 2010. So far, Rathke has not responded to me.

I've been able to identify financial reporting irregularities from just reading and analyzing Green Mountain Coffee's financial reports. However, the class-action lawyers and the SEC have the power to subpoena witnesses and compel the production of internal documents from Green Mountain Coffee and M. Block to get at the bottom of what happened.

Last quarter, Green Mountain Coffee disclosed that it spent about $6 million on "legal and accounting expenses related to the SEC inquiry, the Company’s internal investigation and pending litigation." I don't see any quick resolution of legal issues facing Green Mountain Coffee and the company should expect to spend significantly more money dealing with these issues in future periods. Back on October 21, 2010, I warned Green Mountain Coffee that "Your lawyers will defend you to your very last dollar."

Written by:

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

Disclosure

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

If it weren't for the heroic 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.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.